Deferred Income Taxes

Deferred taxes
Occur when income before tax expense on the income statement is different than taxable income per the IRS tax code.

The difference occurs because of different accounting methods:

The tax expense and tax payable will not agree; deferred tax is the difference

Temporary Difference
A timing difference in when you record a revenue or expense for books (GAAP) and when it is recognized for tax purposes (IRS Code) for the current year

Cumulatively (for all business years) the revenues will equal cash received and expenses will equal cash paid and there will be no difference between what is reported on the tax return (tax) and what is reported on the financial statements (books).

Temporary differences create a deferred tax asset or liability.
An asset or liability is determined by the difference in the future.

Deferred Tax Asset (Initial Debit):
Pay less tax than tax expense in future years

Deferred Tax Liability (Initial Credit):
Pay more tax than tax expense in future years

Deferred Tax Liability
More tax is paid in the future than tax expense

Deducted more expense for tax than books to date
Less tax deductions (tax) than expense (books) in the future
Pay more tax in the future

Reported less revenues for tax than for books to date
More revenue for tax than books in the future
Pay more tax in the future

Examples of Deferred Tax Liabilities:
Prepaid Expenses
Revenue earned not yet received
Accelerated depreciation expense for tax

Deferred Tax Asset
Less tax is paid than tax expense in the future

Deduct less expense for tax to date than books
More tax deductions (tax) than expense (books) in the future
Pay less tax in the future

Reported more revenues for tax than for books to date
Less tax revenue in the future
Pay less tax in the future

Examples of Deferred Tax Assets:
Payables/Accruals not yet paid
Unearned Revenues

Very Important:
Once a difference is determined to be an asset or a liability it remains an asset or liability and is increased or decreased in future years.

Asset/Liability Method
Determine the deferred tax asset and liability and then plug tax expense

Deferred Tax asset/liability =
Cumulative book/tax difference x future tax rate

1) Determine taxable income for books and for tax: Example:

Many items will be the same for GAAP and for tax.
The net of these items that are the same begins the calculation and you then adjust for only items that are different.

2) Record the income tax payable – as calculated

3) Determine the cumulative book/tax differences and multiply by future tax rate
– this is the deferred tax

Book tax difference is 2,000 more expense for tax x 30% = 600

4) Determine if the differences are liabilities or assets

More expense for tax now means less expense for tax in the future.
More taxable income in the future, pay more in the future is a liability

5) Plug the tax expense to balance the journal entry

Tax Expense                       5,400 plug
           Deferred Tax Liability            600
           Tax Payable                          4,800

Required on the balance sheet:

Current:            Net of all current deferred tax assets and liabilities

Noncurrent:     Net of all noncurrent deferred tax assets and liabilities

Do not net all assets and net all liabilities
You can have two assets or two liabilities

Determine if the deferred tax is current or non-current by the asset or liability the book/tax difference is associated with

Current:
Bad debt expense – Accounts Receivable
CGS — Inventory
Warranty expense – Warranty Liability
Unrealized G/L – Short Term Investments
Interest Expense – Interest Payable

Noncurrent:
Depreciation — Property/Plant/Equipment
Amortization — Intangibles

If not associated with anything on the balance sheet, look to the timing of when it reverses, if all next year, then current.

Net Operating Loss (NOL), Taxable Loss:

IRS Regulation (Subject to change with changes in the tax code):

Carry back 2 years and then Carry forward 20 years
Carry back only if the company paid taxes in the past two years

Carry back:
Refund from IRS for taxes paid in the past
(loss x prior year’s tax rate)

Income Tax Receivable
           Income Tax Expense

Carry back losses may not exceed taxable income in the prior two years

Carry forward:
Use in the future to reduce taxable income and tax paid
(loss x future tax rate)

Deferred Tax Asset
             Income Tax Expense

 

Valuation Allowance:

Deferred Tax Asset –
means that in the future taxes paid to the IRS will be less
If this is not the case, then the asset has no value

If no expected future income, taxes paid can’t be less and the deferred tax asset has no value.

If no value, then the asset must be reduced

Tax Expense
           Valuation Allowance

Report on the balance sheet:

   Deferred Tax Asset
– Valuation Allowance
Net Deferred Tax Asset

Situations which cause doubt that the asset will be used to reduce taxes:

1) Losses in recent years (can’t reduce income if no value)
2) History of NOLs expiring before the company makes income and can use them
3) Uncertainty about future income

Situations which support that there is an asset of value:
1) Strong earnings history, expect future taxable income
2) Sales backlogs which indicate earnings will continue
3) Deferred tax liabilities, the asset can be used to offset them in future years.

Establish the valuation allowance, increase tax expense if:

MORE LIKELY THAN NOT the deferred tax asset WON’T BE REALIZED
Determined at the end of the period and the allowance is adjusted to a final balance of the unrealizable amount.

Permanent Differences:

An item that is treated differently for tax than books and affects taxes paid in the current year only.

It is not a timing difference and does not affect future years.

For the current year only, tax payable is higher or lower than tax expense because the item is not reported on the tax return:

Examples:
Penalties/Fines
Insurance premium on officer’s life insurance
Interest Revenue on Municipal Bonds and other nontaxable investments

After computing taxable income, adjust taxable income for the permanent difference before multiplying by tax expense to get the amount that is payable.