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Credit Agreements Many firms arrange loan commitments from banks or insurance companies for future loans. Often, the firm does not intend to obtain these loans but has arranged the credit agreement just in case a need exists for additional funds. Such credit agreements do not represent a liability unless the firm actually requests the funds. From the point of view of analysis, the existence of a substantial credit agreement is a positive condition in that it could relieve pressure on the firm if there is a problem in meeting existing liabilities. In return for giving a credit agreement, the bank or insurance company obtains a fee. This commitment fee is usually a percentage of the unused portion of the commitment. Also, banks often require the firm to keep a specified sum in its bank account, referred to as a compensating balance. Exhibit 3-15 shows credit agreements.

Liabilities Relating to Operational Obligations

Long-term liabilities relating to operational obligations include obligations arising from the operation of a business, mostly of a service nature, such as pension obligations, postretirement benefit obligations other than pension plans, deferred taxes, and service warranties. Chapter 7 covers at length pensions and postretirement benefit obligations other than pension plans. Deferred Taxes Deferred taxes are caused by using different accounting methods for tax and reporting purposes. For example, a firm may use accelerated depreciation for tax purposes and straight-line depreciation for reporting purposes. This causes tax expense for reporting purposes to be higher than taxes payable according to the tax return. The difference is deferred tax. Any situation where revenue or expense is recognized in the financial statements in a different time period than for the tax return will create a deferred tax situation (asset or liability). For example, in the later years of the life of a fixed asset, straight-line depreciation will give higher depreciation and, therefore, lower net income than an accelerated method. Then tax expense for reporting purposes will be lower than taxes payable, and the deferred tax will be reduced (paid). Since firms often buy more and higher-priced assets, however, the increase in deferred taxes may exceed the decrease. In this case, a partial or a total reversal will not occur. The taxes may be deferred for a very long time, perhaps permanently. Chapter 7 covers deferred taxes in more detail. Warranty Obligations Warranty obligations are estimated obligations arising out of product warranties. Product warranties require the seller to correct any deficiencies in quantity, quality, or performance of the product or service for a specific period of time after the sale. Warranty obligations are estimated in order to recognize the obligation at the balance sheet date and to charge the expense to the period of the sale. Exhibit 3-16 shows warranty obligations of Ford Motor Company.

Minority Interest
Minority interest reflects the ownership of minority shareholders in the equity of consolidated subsidiaries less than wholly owned. Minority interest does not represent a liability or stockholders equity in the firm being analyzed. Consider the following simple example. Parent P owns 90% of the common stock of Subsidiary S.
Parent P Subsidiary S Balance Sheet Balance Sheet December 31, 2008 December 31, 2008 (In millions)
Current assets Investment in Subsidiary S Other long-term assets Current liabilities Long-term liabilities Stockholders equity $100 18 382 $500 $100 200 200 $500 $10 40 $50 $10 20 20 $50

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This mixed attribute accounting model does a fairly good job of capturing economic events and transactions in a way that maintains the reliability of the overall financial statements. (Recall the increasing usefulness of financial statements indicated in Exhibit 2.2.) The FASB, and now the IASB, are constantly monitoring the needs of financial statement users and adapt financial reporting rules to those needs. Currently, the FASB and IASB are attempting to overhaul the conceptual frameworks upon which the accounting model is based with the goal of making the accounting for similar events and transactions consistent across firms and across time. However, because of the trade-off between relevance and reliability, it is unlikely that financial reporting will move toward any extreme, such as full historical values or full fair values. Instead, the evolution of the mixed attribute accounting model reflects a continuous improvement in financial reporting that adapts to the evolving needs of financial statement users. Also, an important fact to keep in mind is that the quality of financial reporting can be enhanced (or offset) by other features of the economic environment, such as corporate governance practices, shareholder protection, regulation, and enforcement. For example, Hung (2000) demonstrates that the usefulness of accrual accounting is higher in countries that have institutional features that protect shareholders (such as common law legal systems and shareholders rights provisions).17

INCOME TAXES
In this chapter, the discussion thus far has considered the measurement of assets, liabilities, revenues, gains, expenses, and losses before considering any income tax effects. Everyone is aware that taxes are a significant aspect of doing business, but few understand how taxes impact financial statements. The objective of the brief discussion in this section is to familiarize you with the basic concepts underlying the treatment of income taxes in the financial statements. A more detailed discussion appears in Chapter 8. The fundamental reason for the difficulty in understanding the financial reporting of income taxes is that financial reporting of income uses one set of rules (U.S. GAAP, for example), while taxable income uses another set of rules (the Internal Revenue Code, for example). Reconciling the differences between these sets of rules necessitates the use of various accruals such as deferred income tax assets and liabilities. These differences are analogous to differences between financial reporting rules and cash basis accounting, which necessitate the use of various accruals such as accounts receivable and accounts payable. Thus, an understanding of financial statement analysis requires the appreciation that there are (at least) three primary alternatives by which financial performance can be measured, as shown in Exhibit 2.7. Income taxes affect virtually every transaction in which a firm engages. All of the previous examples face some tax exposure. For example:

Smithfield Foods (in Example 17) writes down its live hog inventory $44 million due to
a decline in the market price for live hogs. However, for tax reporting, Smithfield Foods cannot deduct this write-down immediately, but must wait until the loss is realized through an actual sale of the live hogs. Should Smithfield Foods record the presumed tax benefit that will arise from this write-down now or wait until the loss is realized? Kimpton Hotels (in Example 19) recognizes an $8 million impairment loss on one of its hotels. However, Kimpton Hotels will not be permitted to deduct this impairment for tax reporting immediately, but instead must continue to depreciate or amortize it over time. Thus, U.S. GAAP and the income tax law treat the value of the building and the depreciation expense on it differently. Do these differences matter for financial reporting?

17Mingyi Hung, Accounting Standards and Value Relevance of Financial Statements: An International Analysis, Journal of Accounting & Economics (December 2000).

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EXHIBIT 2.7
Alternative Sets of Rules for Determining Financial Performance Economic transactions and events

Option 1
Report cash inflows and cash outflows

Option 2
Attempt to capture economics, independent of cash flows

Option 3
Use rules specifically designed by taxing authorities to generate public funds, encourage or discourage certain behavior, and redistribute wealth

Cash flows reporting

(Statement of Cash Flows)

Accrual accounting
(U.S. GAAP, IFRS, Australian GAAP, Indian GAAP, etc.)

Tax reporting
(Tax authorities, such as the U.S. Internal Revenue Service)

Microsoft (in Example 20) includes a $400,000 increase in the fair value of marketable
equity securities in other comprehensive income. Microsoft will report the effect of any gains or losses in taxable income only when it sells the securities. Should Microsoft recognize any income tax liability or expense now on the $400,000 of other comprehensive income? To fully understand business transactions, you need to understand their income tax effects. Thus, before specific financial reporting topics are discussed in Chapters 69, an overview of the required accounting for income taxes under U.S. GAAP and IFRS is necessary.

Overview of Financial Reporting of Income Taxes18

Income taxes significantly affect the analysis of a firms reported profitability (income tax expense is a subtraction in computing net income), cash flows (income taxes paid are an operating use of cash), and assets and liabilities (for accrued taxes payable and deferred tax
18Our discussion proceeds as if accounting for income taxes follows an income statement perspective. However, this is not technically correct, as accounting standards require a balance sheet perspective. We have found that exposition using the income statement perspective is more intuitive for students than the technically correct balance sheet perspective,

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EXHIBIT 2.8
Differences in Nomenclature for Financial Reporting and Tax Reporting Financial Reporting Revenues (GAAP) Expenses = Income before taxes (or Pretax income) Income tax expense = Net income Tax Reporting Revenues (tax rules) Deductions = Taxable income Taxes owed [no counterpart]

assets or liabilities). Income tax expense under accrual accounting for a period does not necessarily equal income taxes owed under the tax laws for that period (for which the firm must remit cash). The discussion first helps you clarify nomenclature that differs between financial reporting of income taxes (in financial statements) and elements of income taxes for tax reporting (on income tax returns). Exhibit 2.8 demonstrates the primary differences that will help with the exposition of these differences. Both financial reporting and tax reporting begin with revenues, but revenue recognition rules for financial reporting do not necessarily lead to the same figure for revenues as reported for tax reporting. From there, it is helpful to distinguish between summary items for financial and tax reporting. Under tax reporting, firms report deductions rather than expenses. Revenues less deductions equal taxable income (rather than income before taxes, or pretax income). Finally, taxable income determines taxes owed, which can be substantially different from tax expense on the income statement, as highlighted later in this section. The balance sheet recognizes the difference between the two amounts as deferred tax assets or deferred tax liabilities. The balance sheet also recognizes any taxes owed at year-end (beyond the estimated tax payments firms may have made throughout the year) as a current liability for income taxes payable. A simple example illustrates the issues in accounting for income taxes. Exhibit 2.9 sets forth information for the first two years of a firms operations. The first column for each year shows the financial reporting amounts (referred to as book amounts or financial reporting). The second column shows the amounts reported to income tax authorities (referred to as tax amounts or tax reporting). To clarify some of the differences between book and tax effects in the first two columns, the third column indicates the effect of each item on cash flows. Assume for this example and those throughout this chapter that the income tax rate is 40 percent. Additional information on each item is as follows:

Sales Revenue: The firm reports sales of $500 each year for both book and tax report
ing. Assume that it collects the full amount each year in cash (that is, the firm has no accounts receivable). Interest Income on Municipal Bonds: The firm earns $25 of interest on municipal bonds. The firm includes this amount in its book income. The federal government does not tax interest on state and municipal bonds, so this amount is excluded from taxable income. Depreciation Expense: The firm has equipment costing $120 with a two-year life. It depreciates the equipment using the straight-line method for financial reporting, recognizing $60 of depreciation expense on its books each year. Income taxing authorities permit the firm to write off a larger portion of the assets cost in the first year, $80, than

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EXHIBIT 2.9
Illustration of the Effects of Income Taxes on Net Income, Taxable Income, and Cash Flows First Year Book Amounts Sales revenue Interest on municipal bonds Depreciation expense Warranty expense Other expenses Net Income before Taxes or Taxable Income Income tax expense or payable Net Income Net Cash Flows $500 25 (60) (10) (300) $155 (52) $103 $174.6 Tax Amounts $500 (80) (4) (300) $116 $ (46.4) (46.4) Cash Flow Amounts $500 25 (4) (300) Book Amounts $500 25 (60) (10) (300) $155 (52) $103 $153.8 Second Year Tax Amounts $500 (40) (12) (300) $148 $ (59.2) (59.2) Cash Flow Amounts $500 25 (12) (300)

can be done using the straight-line method. Because total depreciation over the life of an asset cannot exceed acquisition cost, the firm recognizes only $40 of depreciation for tax reporting in the second year. Warranty Expense: The firm estimates that the cost of providing warranty services on products sold equals 2 percent of sales. It recognizes warranty expense of $10 ( 0.02 $500) each year for financial reporting, which matches the estimated cost of warranties against the revenue from the sale of products subject to warranty. Income tax laws do not permit firms to claim a deduction for warranties in computing taxable income until they make cash expenditures to provide warranty services. Assume that the firm incurs cash costs of $4 in the first year and $12 in the second year. Other Expenses: The firm incurs and pays other expenses of $300 each year. Income before Taxes and Taxable Income: Based on the preceding assumptions, income before taxes for financial reporting is $155 each year. Taxable income is $116 in the first year and $148 in the second year. Taxes Payable: Assume that the firm pays all income taxes payable at each year-end. Income before taxes for financial reporting differs from taxable income for the following principal reasons: 1. Permanent Differences: Revenues and expenses that firms include in net income for financial reporting but that never appear in the income tax return. Interest revenue on the municipal bond is a permanent revenue difference. Examples of expenses that would be disallowed as deductions include executive compensation above a specified cap, certain entertainment expenses, political and lobbying expenses, and some fees and penalties.

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2. Temporary Differences: Revenues and expenses that firms include in both net income and taxable income but in different periods. Thus, the differences are temporary until they reverse. Depreciation expense is a temporary difference. The firm recognizes total depreciation of $120 over the life of the equipment for both financial and tax reporting but in a different pattern over time. Similarly, warranty expense is also a temporary difference. The firm recognizes a total of $20 of warranty expense over the two-year period for financial reporting. It deducts only $16 over the two-year period for tax reporting. If the firms estimate of total warranty costs turns out to be correct, the firm will deduct the remaining $4 of warranty expense for tax reporting in future years when it provides warranty services. A central conceptual question in accounting for income taxes concerns the measurement of income tax expense on the income statement for financial reporting. 1. Should the firm compute income tax expense based on book income before taxes ($155 for each year in Exhibit 2.9)? 2. Should the firm compute income tax expense based on book income before taxes but excluding permanent differences ([$130 $155 $25] for each year in Exhibit 2.9)? 3. Should the firm compute income tax expense based on taxable income ($116 in the first year and $148 in the second year in Exhibit 2.9)? U.S. GAAP and IFRS require firms to follow the second approach, which complicates an understanding of income tax accounting because the amount upon which tax expense is based does not necessarily appear on the income statement (that is, income before taxes minus permanent differences). For this reason, U.S. GAAP and IFRS require a footnote that shows how the firm calculates income tax expense. This should clear up a misconception that income tax expense is the amount of income taxes currently owed (the third approach). If a firm does not have any permanent differences, there is no difference between the first and second approaches. The rationale behind basing income tax expense on income before taxes (minus permanent differences) is that it aligns the recognition of all tax consequences of items and events already recognized in the financial statements or on tax returns in the period they occur. Thus, firms must recognize the expected benefits of future tax deductions and the obligations related to future taxable income that arise because of temporary differences each year. Permanent differences do not affect taxable income or income taxes paid in any year, and firms do not recognize income tax expense or income tax savings on permanent differences. Thus, under the second approach, income tax expense is $52 ( 0.40 $130) in each year. The journal entry to recognize income tax expense for the first year is as follows:
Income Tax Expense Deferred Tax AssetWarranty Deferred Tax LiabilityDepreciation Cash 52.0 2.4 8.0 46.4 (0.40 (0.40 (0.40 (0.40 130) 6) 20) 116)

Income tax expense of 52.0 is recognized, which reduces net income, whereas the firm only pays cash taxes of 46.4. The deferred tax asset measures the future tax saving that the firm will realize when it provides warranty services in future years and claims a tax deduction for the realization of expenses that are estimated in the first year. The firm expects to incur $6 ( $10 $4) of warranty costs in the second year and later years. When it incurs these costs, it will reduce its taxable income, which will result in lower taxes owed for the

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year, all else equal. Hence, the deferred tax asset of $2.4 ( 0.40 $6) reflects this future deductibility of amounts already expensed for financial reporting but not yet deducted for tax reporting. The $8 ( 0.40 $20) deferred tax liability measures taxes that the firm must pay in the second year when it recognizes $20 less depreciation for tax reporting than for financial reporting. The following summarizes the differences between book and tax amounts and the underlying cash flows. The $25 of interest on municipal bonds is a cash flow, but it is not reported on the tax return. (It is a permanent difference.) Depreciation is an expense that is a temporary difference between tax reporting and financial reporting but does not use cash. The firm recognized warranty expense of $10 in measuring net income but used only $4 of cash in satisfying warranty claims, which is the amount allowed to be deducted on the tax return. Finally, the firm recognized $52 of income tax expense in measuring net income but used only $46.4 cash for income taxes due to permanent and temporary differences. Overall, net income is $103, taxable income is $116, and cash flows are $174.6. The largest discrepancy between net income and cash flows is depreciation, which is true generally. In the second year, the journal entry to recognize the income tax effects is as follows:
Income Tax Expense Deferred Tax LiabilityDepreciation Deferred Tax AssetWarranty Cash 52.0 8.0 0.8 59.2 (0.40 (0.40 (0.40 (0.40 130) 20) 2) 148)

As in the first year, income tax is recognized as the effective tax rate times the pretax income, and cash paid for taxes equals the tax rate times taxable income. The temporary difference related to depreciation completely reverses in the second year, so the firm reduces the deferred tax liability to zero, which increases income taxes currently payable by $8. The temporary difference related to the warranty partially reversed during the second year, but the firm created additional temporary differences in that year by making another estimate of future warranty expense. For the two years as a whole, warranty expense for financial reporting of $20 ( $10 $10) exceeds the amount recognized for tax reporting of $16 ( $4 $12). Thus, the firm will recognize tax savings of $1.6 ( 0.40 $4) in future years (a deferred tax asset). The deferred tax asset had a balance of $2.4 at the end of the first year, so the adjustment in the second year reduces the balance of the deferred tax asset by $0.8 ( $2.4 $1.6). Now consider the cash flow effects for the second year. Cash flow from operations is $153.8. Again, depreciation expense is a non-cash expense of $60. The firm recognized warranty expense of $10 for financial reporting but used $12 of cash to satisfy warranty claims. The $2 subtraction also equals the net reduction in the warranty liability accounting during the second year, as the following analysis shows: Warranty Liability, beginning of second year Warranty Expense, second year Warranty Claims, second year Warranty Liability, end of second year $ 6 10 (12) $ 4

The firm recognized $52 of income tax expense but used $59.2 of cash for income taxes. The additional $7.2 of cash used to pay taxes in excess of the tax expense reduces the net deferred tax liability position. The $7.2 subtraction also equals the net change in the

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Deferred Tax Asset ($0.8 decrease) and Deferred Tax Liability ($8 decrease) during the second year, as the following analysis shows: Net Deferred Tax Liability,19 beginning of second year ($8 liability Income Tax Expense, second year Income Taxes Paid, second year Net Deferred Tax Asset, end of second year ($0 liability $1.6 asset) $2.4 asset) $ 5.6 52.0 (59.2) $ (1.6)

Measuring Income Tax Expense: A Bit More to the Story (to Be Technically Correct)
The preceding illustration followed what might be termed an income statement approach to measuring income tax expense. It compared revenues and expenses recognized for book and tax purposes, eliminated permanent differences, and computed income tax expense based on book income before taxes excluding permanent differences. However, FASB Statement No. 109 and IAS 1220 require firms to follow a balance sheet approach when computing income tax expense. For example, Statement No. 109 states the following: a difference between the tax basis of an asset or a liability and its reported amount in the [balance sheet] will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled (para. 11). Similarly, IAS 12 states It is inherent in the recognition of an asset or liability that the reporting entity expects to recover or settle the carrying amount of that asset or liability. If it is probable that recovery or settlement of that carrying amount will make future tax payments larger (smaller) than they would be if such recovery or settlement were to have no tax consequences, this Standard requires an entity to recognize a deferred tax liability (deferred tax asset), with certain limited exceptions. Thus, in the context of the preceding example, the perspective under the balance sheet approach is as follows: Step 1. In the illustration, the book basis (that is, the amount on the balance sheet) of the equipment at the end of the first year is $60 ( $120 $60) and the tax basis (that is, what would appear if the firm prepared a tax reporting balance sheet) is $40 ( $120 $80). Both the book and tax basis are zero at the end of the second year. The book basis of the warranty liability at the end of the first year is $6 ( $10 $4), and the tax basis is zero. That is, the firm recognizes a deduction for tax purposes when it pays warranty claims and would therefore show no liability if it were to prepare a tax balance sheet.) The book basis of the warranty liability at the end of the second year is $4 ( $6 $10 $12), and the tax basis remains zero. Step 2. After identifying book and tax differences, eliminate those that will not have a future tax consequence (that is, permanent differences). There are no permanent
19 We are presenting the net change in deferred tax balances for ease of presentation. However, note that the deferred tax liability for the equipment would be classified as noncurrent and the deferred tax asset for the warranties is (usually) classified as current, so in practice deferred taxes do not appear net. 20 Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (1992). FASB Codification Topic 740; International Accounting Standards Committee, International Accounting Standards No. 12, Income Taxes (October 1996).

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differences in the book and tax bases of assets and liabilities in the example. However, suppose the firm had not yet received the $25 of interest on the municipal bond investment by the end of the first year. It would show an interest receivable on its financial reporting balance sheet of $25, but no receivable would appear on its tax balance sheet. Because the tax law does not tax such interest, the difference between the book and tax basis is a permanent difference. The firm would eliminate this book-tax difference before moving to the next step. Step 3. Next, separate the remaining differences into those that give rise to future tax deductions and those that give rise to future taxable income. Exhibit 2.10 summarizes the possibilities and gives several examples of these temporary differences, as later chapters discuss. The difference between the book basis ($6) and the tax basis ($0) of the warranty liability at the end of the first year means that the firm will have future tax deductions (assuming that the book basis of the estimate is accurate). The difference between the book basis ($60) and the tax basis ($40) of the equipment at the end of the first year gives rise to future taxable income (meaning that depreciation deductions will be lower, which will increase taxable income, all else equal). We multiply these differences by the marginal tax rate expected to apply in those future periods. In the example, the future tax deduction for the warranties results in a deferred tax asset at the end of the first year of $2.4 ( 0.40 [$6 book basis $0 tax basis]). The future taxable income (due to the lower future depreciation of the equipment) results in a deferred tax liability at the end of the first year of $8 ( 0.40 [$60 book basis $40 tax basis]).

EXHIBIT 2.10
Examples of Temporary Differences Assets Future Tax Deduction (results in deferred tax assets) Tax basis of assets exceeds financial reporting basis. Example: Accounts receivable using the direct charge-off method for uncollectible accounts for tax purposes exceeds accounts receivable (net) using the allowance method for financial reporting. Liabilities Tax basis of liabilities is less than financial reporting basis. Example: Tax reporting does not recognize an estimated liability for warranty claims (firms can deduct only actual expenditures on warranty claims), whereas firms must recognize such a liability for financial reporting to match warranty expense with sales revenue in the period of sale. Tax basis of liabilities exceeds financial reporting basis. Example: Leases are recognized by a lessee, the user of the leased assets, as a capital lease for tax reporting and an operating lease for financial reporting.

Future Taxable Income (results in deferred tax liabilities)

Tax basis of assets is less than financial reporting basis. Example: Depreciation is computed using accelerated depreciation for tax purposes and the straight-line method for financial reporting.

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Step 4. Finally, the rules for income tax accounting require managers to assess the likelihood that the firm will realize the future benefits of any recognized deferred tax assets. This assessment should consider the nature (whether cyclical or noncyclical, for example) and characteristics (growing, mature, or declining, for example) of a firms business and its tax planning strategies for the future. If realization of the benefits of deferred tax assets is more likely than not (that is, exceeds 50 percent), then deferred tax assets equal the amounts computed in Step 3. However, if it is more likely than not that the firm will not realize some or all of the deferred tax assets, then the firm must reduce the deferred tax asset using a valuation allowance (similar in concept to the allowance for uncollectible accounts receivable). The valuation allowance reduces the deferred tax assets to the amounts the firm expects to realize in the form of lower tax payments in the future (similar to a net realizable value approach). For purposes here, assume that the firm in the preceding illustration considers it more likely than not that it will realize the tax benefits of the deferred tax assets related to warranties and therefore recognizes no valuation allowance. The result of this four-step procedure for the example is a deferred tax asset and a deferred tax liability at each balance sheet date. The amounts in the preceding illustration are as follows: January 1, First Year Deferred Tax AssetWarranties Deferred Tax LiabilityEquipment $0.0 0.0 December 31, First Year $2.4 8.0 December 31, Second Year $1.6 0.0

Income tax expense for each period equals: 1. Income taxes currently payable on taxable income 2. Plus (minus) any increases (decreases) in deferred tax liabilities 3. Plus (minus) any decreases (increases) in deferred tax assets. Thus, income tax expense in the preceding illustration is as follows: First Year Income Taxes Currently Payable on Taxable Income Plus (Minus) Increase (Decrease) in Deferred Liability Minus (Plus) Increase (Decrease) in Deferred Tax Asset Income Tax Expense $46.4 8.0 (2.4) $52.0 Second Year $59.2 (8.0) 0.8 $52.0

The income statement approach illustrated in the first section and the balance sheet approach illustrated in this section yield identical results whenever (1) enacted tax rates applicable to future periods do not change and (2) the firm recognizes no valuation allowance on deferred tax assets. Legislated changes in tax rates applicable to future periods will cause the tax effects of previously recognized temporary differences to differ from the amounts in the deferred tax asset and deferred tax liability accounts. The firm revalues the deferred tax assets and liabilities for the change in tax rates and flows through the effect of the change to income tax expense in the year of the legislated change. A change in the valuation allowance for deferred tax assets likewise flows through immediately to income tax expense.

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Reporting Income Taxes in the Financial Statements

Understanding income tax accounting becomes difficult because firms may not include all income taxes for a period on the line for income tax expense in the income statement. Some amounts may appear elsewhere:

Discontinued Operations and Extraordinary Items: Under U.S. GAAP, firms with
either of these categories of income for a particular period report them in separate sections of the income statement, each net of their income tax effects. Thus, income tax expense reflects income taxes on income from continuing operations only. IFRS does not permit extraordinary item categorizations, but exceptional or material items may be disclosed separately, including income tax effects. Other Comprehensive Income: Unrealized changes in the market value of marketable securities classified as available for sale, unrealized changes in the market value of hedged financial instruments and derivatives classified as cash flow hedges, unrealized foreign currency translation adjustments, and certain changes in pension and other post-employment benefit assets and liabilities appear in other comprehensive income, net of their tax effects. These items usually give rise to deferred tax assets or deferred tax liabilities because the income tax law includes such gains and losses in taxable income when realized. Thus, a portion of the change in deferred tax assets and liabilities on the balance sheet does not flow through income tax expense on the income statement.

PepsiCos Reporting of Income Taxes

PepsiCo reports information on income taxes in Note 5, Income Taxes, to its financial statements (Appendix A), excerpts of which appear in Exhibit 2.11. Income tax expense for 2008 of $1,879 million includes $1,634 million currently owed and $245 million deferred. Thus, excluding permanent differences, PepsiCos income for financial reporting exceeded its taxable income for 2008 (as evidenced by the $245 of deferred tax expense, reflecting income tax liabilities that will be due in the future). In contrast, for 2007, income taxes currently owed exceeds total income tax expense, suggesting that PepsiCos taxable income exceeded its income for financial reporting (consistent with the reversal of previously deferred income tax liabilities). At the end of 2008, PepsiCos deferred tax assets exceeded its deferred tax liabilities, for a net deferred tax asset of $168 million. In the previous year, PepsiCo ended with deferred tax liabilities in excess of deferred tax assets, for a net deferred tax liability of $321 million. The $489 million change from a net deferred tax liability to a net deferred tax asset differs substantially from the amount of deferred tax expense of $245 million (a combined discrepancy of $734 million $489 million deferred tax benefit minus $245 million expense). This difference reflects a number of items, but a large explanation for the difference between the change in the deferred tax amounts on the balance sheet and deferred tax expense relates to the components of other comprehensive income shown in the Statement of Shareholders Equity and accumulated other comprehensive loss, shown in Note 13, Accumulated Other Comprehensive Loss (Appendix A). For example, the large adjustment for Unamortized pension and retiree medical, net of tax includes approximately $643 million of tax adjustments for 2008 other comprehensive income ( $1,288 tax effect for 2008 minus the $645 tax effect for 2007), which offset declines in the fair value of pension and retiree medical assets during 2008 of approximately $2.2 billion ( $5,782 $1,595 $3,974 $1,165), as reported in Note 7, Pension, Retiree Medical and Savings Plans (Appendix A). The complexity of accounting for deferred taxes makes it difficult to fully reconcile deferred tax expense to changes in the balance sheet accounts.

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EXHIBIT 2.11
Excerpts from PepsiCos Note 5 on Income Taxes (amounts in millions) Income Statement for Year: Provision for income taxescontinuing operations: Current Deferred Total Balance Sheet at End of Year: Gross deferred tax liabilities (details omitted) Gross deferred tax assets (details omitted) Valuation allowances Deferred tax assets, net Net Deferred Tax (Assets) Liabilities 2008 $1,634 245 $1,879 2008 $2,442 $3,267 (657) $2,610 $ (168) 2008 Deferred taxes included within: ASSETS: Prepaid expenses and other current assets Other assets LIABILITIES: Deferred income taxes Analysis of valuation allowances: Balance, beginning of year (Benefit) / Provision Other (deductions) / additions Balance, end of year 2007 $2,015 (42) $1,973 2007 $2,555 $2,929 (695) $2,234 $ 321 2007 2006 $1,401 (54) $1,347

$ 372 22 226 695 (5) (33) $ 657

$ 325 646 624 39 32 $ 695

Note that Exhibit 2.11 also indicates that PepsiCos gross deferred tax assets in both 2007 and 2008 were accompanied by valuation allowances. For 2008, the valuation allowance was $657 million on the gross deferred tax assets of $3,267 million. The valuation allowance likely relates to $7.2 billion of operating loss carryforwards (which create large deferred tax assets) that have various expiration dates. (See Note 5 to PepsiCos financial statements in Appendix A.) If PepsiCos management determines that it is more likely than not that some portion of these carryforwards will not be able to be used, a valuation allowance must be established. Finally, the last table in Exhibit 2.11 indicates that PepsiCos deferred tax assets and liabilities appear in three locations on the balance sheetcurrent assets (Prepaid expenses and other current assets), noncurrent assets (Other assets), and noncurrent liabilities (Deferred income taxes). You will return to the study of income taxes in Chapter 8 to explore in greater depth the concepts and procedures of accounting for income taxes, which you may find challenging.