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Deferred Taxes - What Are They?
The Federal tax code is designed to collect revenue and
influence behavior, not principally to measure income
Accrual accounting is designed to measure income
Many items properly receive different treatment under the
two methods, with tax accounting often being more cash basis
In accrual accounting, all taxes that will eventually be paid as
a result of income generated this year should be included in
expense this year on the income statement
Deferred taxes arise because of eventual tax expense not
equaling tax payable in a given year
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Terms
Temporary Difference - An item that has a tax impact at a
different time than a book impact, but will be the same in the
end.
Permanent Difference - An item that has a different tax
treatment than book treatment that will not reverse
Future deductible amount - An amount that decreases taxable
income in the future (and increases it now )
Future taxable amount - An amount that increases taxable
income in the future (and decreases it now )
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Calculating Tax Expense
The FASB has endorsed an asset/liability approach to deferred
taxes. Thus, to calculate them, we:
1. Determine taxes payable from the tax return
2. Determine the amount of deferred tax assets and liabilities
that exist at year end based on future taxable and deductible
amounts and adjust them to the appropriate balances.
3. Plug tax expense (in most cases, tax expense should equal
the book income adjusted for any permanent differences,
times the tax rate).
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Example - Single Temporary Difference
Income
Year Before Dep
98
500000
99
500000
00
500000
Depreciation Taxable
Tax
Tax
Book Income Payable
250000 166667 250000
87500
150000 166666 350000 122500
100000 166667 400000 140000
98 Tax Expense
116,667
Deferred taxes
Tax payable
99 Tax Expense
116,664
Deferred taxes
5,834
Tax payable
00 Tax Expense
116,667
Deferred taxes
23,333
Tax payable
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Asset
Asset
Future
Deferred
Book
Tax
Taxable
Tax
Basis
Basis Amount Liability
333333 250000
83333 29166.55
166667 100000
66667 23333.45
0
0
0
0
29,167
87,500
122,500
140,000
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Deferred Tax Assets and Valuation Accounts
Some questions exist as to the realizability of a deferred tax
asset as the amount depends on the existence of future taxable
income.
FASB has concluded that a deferred tax asset should be
recognized for all future deductible amounts.
If it is "more likely than not" that some portion of a deferred tax
asset will not be realized, a valuation allowance should be
established, with the debit to income tax expense.
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Financial Statement Presentation
Income tax expense should be reported showing both the
current portion (taxes payable) and deferred portion. Taxes
should be shown separately for income from continuing
operations, discontinued operations, extraordinary items and
cumulative changes in accounting principle. Ex 26
On the balance sheet, deferred taxes should be separated into
current and noncurrent amounts, and each should have the
assets and liabilities netted.
Assets and liabilities are classified as current based on first
identifying them with the underlying asset that gives rise to
them, and if that is not possible, based on the date they are
expected to reverse.
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Tax Rate Changes
Deferred taxes should be based on the future tax rates in effect
at the end of the reporting period.
If future tax rates change, then the balance in the deferred tax
accounts must be changed, with the related effect going into
income taxes (this could be large).
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Carrybacks and Carryforwards
If a corporation sustains a tax loss for the year, it may carry it
back for 2 years or forward for 20 years.
When using a carryback, reduce tax expense by the carryback
realized.
When using a carryforward, recognize a deferred tax asset and
reduce tax expense.
For carryforwards, a valuation allowance may again be
necessary.
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