Insight into Deferred Taxes

How Do Deferred Taxes Arise?

Differences exist between the accounting books and the tax books because of temporary differences
Depreciation Inventory Restructuring charges Allowance for bad debts

Ignore permanent differences

Examples: Goodwill, tax-free income, ...
FIN 551: Fundamental Analysis 2

FIN 551: Fundamental Analysis

Components of Deferred Taxes

Deferred taxes separated into
Short-term and long-term components Assets and liabilities

Deferred tax liabilities

Debt or equity?
When is reversal expected? Continual growth: Maybe no reversal.

FIN 551: Fundamental Analysis

Financial Statement Presentation

On the balance sheet, an enterprise should separate deferred tax liabilities and assets into a current amount and a non-current amount. Deferred tax liabilities and assets should be classified as current or non-current based on the classification of the related asset or liability for financial reporting.
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FIN 551: Fundamental Analysis

Changing Tax Rates

What is the effect of changing tax rates? Rule:
Establish deferred taxes at the rate expected to exist when the timing difference reverses

Tax increase:
Debit: Tax expense Credit: Deferred tax liability

Tax decrease:
Debit: Deferred tax liability Credit: Tax expense.
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The Thought Process

Deferred tax liability
Accounting books show more income than tax books

Deferred tax asset

Tax books show more income than accounting books May have a partially/entire offsetting valuation allowance.
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FIN 551: Fundamental Analysis

Thought Process: Deferred Tax Liability

Increase in deferred tax liability
Expense more (or revenue less) on the tax books than on the accounting books

Reverse the logic for a decrease in the deferred tax liability Example:
$100 depreciation on accounting books; $150 depreciation on tax books
Deferred tax liability increases $50 * tax rate.
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Thought Process: Deferred Tax Asset

Increase in deferred tax asset
Expense less (or revenue more) on the tax books than on the accounting books

Reverse the logic for a decrease in the deferred tax asset Example:
$100 restructuring charge on accounting books; $0 restructuring on tax books until money spent
Deferred tax asset increases $100 * tax rate Like a prepayment of taxes.
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FIN 551: Fundamental Analysis

Temporary Differences Effect

Revenue/ Expense When recorded in books relatively to the taxable income Deferred tax effect

Revenue Revenue Expense Expense

Earlier Later Earlier Later

FIN 551: Fundamental Analysis

Liability Asset Asset Liability

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Basic Journal Entry to Record Deferred Taxes

Tax Liability

Income Tax Expense xxx Def.Tax Liability Taxes Payable

Tax Asset

xxx xxx

Income Tax Expense Def. Tax Asset Taxes Payable

FIN 551: Fundamental Analysis

xxx xxx xxx

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FIN 551: Fundamental Analysis

Valuation Allowance
Deferred tax asset balance may be reduced by a valuation allowance Allowance represents managements concern about not being able to generate enough future accounting income to utilize deferred tax assets Reduction in deferred tax asset means
Debit: Tax expense Credit: Deferred tax asset.
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Analyze Deferred Taxes

03 02 01

Currently payable Federal State Total Deferred Total

17.3 3.7 21.0 30.0 51.0

1.0 3.7 4.7 33.0 37.7

6.6 2.2 8.8 29.0 37.8

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FIN 551: Fundamental Analysis

FIN 551: Fundamental Analysis

Breakdown of Deferred Taxes

03 02 Customer leases 27.6 33.8 Spare parts 59.0 Depreciation 8.3 9.3 Other 9.5 4.9 Tax loss & carryfwds -74.4 -15.0 Total 30.0 33.0
FIN 551: Fundamental Analysis

01 15.5 2.2 7.9 -5.4 29.0

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Example: Deferred Tax Liability -

Depreciation

Bryant Corporation purchased a new machine for $100,000 on January 1, 2001 The machine has a four-year estimated service life and no salvage value Bryants pretax income for each year 2001 - 2004 is 200,000 before depreciation and taxes.
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FIN 551: Fundamental Analysis

Example
Bryant Corp. uses straight-line depreciation on its books and MACRS for tax reporting For tax purposes the machine is also depreciated over 4 years using MACRS (an accelerated depreciation method) The depreciation percentages for each of the years are 33%, 44%, 15% and 8% Assume a 40% tax rate.
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Example
A. Compute financial (book) income after depreciation but before taxes. What is income tax expense? B. Compute taxable income. What is income tax payable? C. Give the journal entries to record taxes. D. Give the balance of the deferred tax liability at the end of each of the years.
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FIN 551: Fundamental Analysis

Solution
A.
Financial (book) income Income before Depreciation Depreciation Expense ($100,000/4) Income after depreciation but before taxes Income Tax Expense (40%) 2001 2002 2003 2004 $200,000 (25,000) $175,000 $70,000

$200,000 $200,000 $200,000 (25,000) (25,000) (25,000)

$175,000 $175,000 $175,000 $70,000 $70,000 $70,000

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Solution
B.
2001
Pre-Tax Income before Depreciation Depreciation Deduction: Taxable Income Income Taxable Payable (40%) $200,000 (33,000) $167,000 $66,800

2002
$200,000 (44,000) $156,000 $62,400

2003
$200,000 (15,000) $185,000 $74,000

2004
$200,000 (8,000) $192,000 $76,800

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FIN 551: Fundamental Analysis

Solution
C. Journal entries: 2001 Income Tax Expense Tax Payable Deferred Tax Liability 2002 Income Tax Expense Tax Payable Deferred Tax Liability
FIN 551: Fundamental Analysis

70,000 66,800 3,200

70,000 62,400 7,600

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Solution
2003 Income Tax Expense Deferred Tax Liability Tax Payable 2004 Income Tax Expense Deferred Tax Liability Tax Payable 70,000 6,800 76,800 70,000 4,000 74,000

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FIN 551: Fundamental Analysis

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Solution
D. The deferred tax liability account Dr. Cr. 3,200 3,200 7,600 10,800 4,000 6,800 6,800 0 The liability has reversed itself
FIN 551: Fundamental Analysis 21

2001 entry 12/31/2001 2002 entry 12/31/2002 2003 entry 12/31/2003 2004 entry 12/31/2004

Example: Deferred Tax Liability Advances from Customers

Miller Co. received $30,000 of subscriptions in advance at the end of 2001 Subscription revenue will be equally recognized in 2002, 2003, and 2004, for financial accounting purposes
All of the $30,000 will be recognized in 2001 for tax purposes

Pretax income for each year 2001-2004 is $100,000 -- assume a 40% tax rate.
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FIN 551: Fundamental Analysis

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Questions
A. Compute Financial (book) income including subscription revenue but excluding taxes. What is income tax expense? B. Compute taxable income. What is income tax payable? C. Give the journal entries to record taxes. D. Give the balance of the deferred tax asset at the end of each of the years.
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Questions
E. For this requirement only, assume that as a result of examining available evidence in 2004, it is more likely than not that $10,000 of the deferred tax asset will not be realized
Give the journal entry to record this reduction.

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FIN 551: Fundamental Analysis

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Solution
A.
2001 Financial (book) income Income before subscription Subscription revenue received in 2004 Income before taxes Income tax expense (40%) 100,000 0 100,000 40,000 100,000 10,000 110,000 44,000 100,000 10,000 110,000 44,000 100,000 10,000 110,000 44,000 2002 2003 2004

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Solution
2001 Pretax income Subscription received in 2001 Taxable Income Taxes Payable (40%) 100,000 30,000 130,000 52,000 2002 100,000 100,000 40,000 2003 100,000 100,000 40,000 2004 100,000 100,000 40,000

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FIN 551: Fundamental Analysis

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Solution
C. Journal entries 2001 Income tax expense Deferred tax asset Tax payable 2002 - 2004 Income tax expense Deferred tax asset Tax payable

40,000 12,000 52,000

44,000 4,000 40,000

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FIN 551: Fundamental Analysis

Solution
D. The deferred tax asset account
Dr. 12,000 12,000 4,000 8,000 4,000 4,000 4,000 0 Cr. 2001 entry 12/31/2001 2002 entry 12/31/2002 2003 entry 12/31/2003 2004 entry 12/31/2004

The asset has reversed itself.

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FIN 551: Fundamental Analysis

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Solution
E.
Income Tax Expense Allowance to Reduce Deferred Tax Asset To Expected Realizable Value 10,000 10,000

To record the reduction in the deferred tax asset

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Example: Permanent Differences Calculation

Hunter Corporation reports the following information for 2004:
Financial (Book) Income before Income Taxes Income Taxes Payable (for 2004) Income Tax Expense $548,000 157,500 210,000

Hunter Corp. has both temporary and permanent differences between book income and taxable income Temporary difference results from depreciation Permanent difference results from a fine that the company has to pay (but can not be deducted on its tax return).
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FIN 551: Fundamental Analysis

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Question
What is the amount of the permanent difference for the year? The tax rate is 35%.

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Solution
Step 1: Find the change in the deferred tax liability Income Tax Expense (Book) $210,000 Income Taxes Payable 157,500 Deferred Tax Liability 52,500 Step 2: Find the temporary difference Deferred Tax Liability/0.35

$52,500/0.35= 150,000

Step 3: Find taxable income Income Taxes Payable (from current year)/0.35 $157,500/0.35= 450,000
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FIN 551: Fundamental Analysis

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Solution
Step 4: Find the permanent difference Taxable Income (IRS) $450,000 Temporary Differences 150,000 Financial (Book) Income before Taxes Excluding Permanent Differences 600,000 Permanent Differences (P.N) 52,000 Financial (Book) Income before Taxes 548,000

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The End

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FIN 551: Fundamental Analysis

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