📈Financial Accounting II Unit 7 – Income Taxes: Deferred & Temporary Differences

Key Concepts

• Income taxes are a significant expense for most companies and can have a material impact on financial statements
• Differences between financial accounting (book) and tax accounting (tax) rules lead to temporary and permanent differences
• Temporary differences arise when the timing of revenue or expense recognition differs between book and tax, resulting in deferred tax assets or liabilities
  • These differences will reverse in future periods
• Permanent differences occur when certain items are recognized for book or tax purposes, but never for the other, and do not result in deferred taxes
• Deferred tax assets represent future tax deductions or credits, while deferred tax liabilities represent future taxable amounts
• Companies must account for the tax effects of temporary differences using the asset-liability method, which involves calculating deferred taxes based on enacted tax rates
• Deferred taxes are classified as non-current assets or liabilities on the balance sheet
• Changes in deferred taxes are included as part of income tax expense on the income statement

Types of Differences

• Temporary differences are the primary focus when accounting for deferred taxes and arise due to timing differences between book and tax recognition
  • Originating temporary differences occur in the current period and will reverse in future periods
  • Reversing temporary differences are the opposite of originating differences and occur when previous temporary differences reverse
• Permanent differences do not result in deferred taxes as they are never recognized for book or tax purposes
  • Examples include certain penalties, fines, and tax-exempt income
• Quasi-permanent differences are temporary differences that are not expected to reverse for a long period, such as indefinite-lived intangibles
• Valuation allowances may be necessary for deferred tax assets if it is more likely than not that some portion will not be realized
  • This assessment is based on available positive and negative evidence
• Changes in tax rates or laws can also impact deferred taxes and require adjustments to reflect the new rates

Temporary Differences Explained

• Temporary differences arise when the book basis and tax basis of an asset or liability differ, leading to future taxable or deductible amounts
• Common types of temporary differences include depreciation, accrued expenses, and revenue recognition
  • Accelerated tax depreciation results in a deferred tax liability as the tax deduction is taken earlier than the book expense
  • Accrued expenses (vacation pay) may be deducted for book purposes before they are deductible for tax purposes, resulting in a deferred tax asset
• The reversal of temporary differences occurs when the book and tax bases converge, typically through the recognition of income or expense
• Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply when the temporary differences reverse
  • This requires scheduling the reversal of temporary differences and applying the appropriate tax rates
• Companies must track and maintain detailed schedules of temporary differences to ensure proper accounting and disclosure
• Temporary differences impact only the timing of tax payments, not the total amount of taxes paid over the life of the asset or liability

Deferred Tax Assets and Liabilities

• Deferred tax assets represent future tax deductions or credits that will result in a reduction of taxes payable in future periods
  • Examples include accrued expenses, net operating losses, and tax credit carryforwards
• Deferred tax liabilities represent future taxable amounts that will result in an increase in taxes payable in future periods
  • Examples include accelerated tax depreciation and installment sales
• Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply when the temporary differences reverse
• Valuation allowances are recorded against deferred tax assets if it is more likely than not that some portion will not be realized
  • This assessment considers available positive and negative evidence, such as future taxable income and tax planning strategies
• Deferred tax assets and liabilities are classified as non-current on the balance sheet and are not discounted to present value
• Changes in deferred tax assets and liabilities are included as part of income tax expense on the income statement

Calculation Methods

• The asset-liability method is the required approach for calculating deferred taxes under both IFRS and U.S. GAAP
  • This method focuses on the balance sheet and calculates deferred taxes based on the temporary differences between the book and tax bases of assets and liabilities
• The deferred tax expense or benefit is determined by the change in deferred tax assets and liabilities during the period
  • This change is then added to or subtracted from the current tax expense to arrive at the total income tax expense
• Enacted tax rates are used to measure deferred tax assets and liabilities, requiring companies to adjust deferred taxes when tax rates change
  • This adjustment is included as part of income tax expense in the period of enactment
• Scheduling the reversal of temporary differences is necessary to determine the appropriate tax rates to apply and assess the need for valuation allowances
• The calculation of deferred taxes can be complex, particularly for companies with multiple jurisdictions and varying tax rates
• Companies must maintain detailed records of temporary differences and their reversals to ensure accurate calculation and reporting of deferred taxes

Financial Statement Impact

• Deferred tax assets and liabilities are presented on the balance sheet as non-current items, typically netted by tax jurisdiction
• Changes in deferred taxes are included as part of income tax expense on the income statement, impacting net income
  • This can cause the effective tax rate to differ from the statutory tax rate
• Valuation allowances are recorded against deferred tax assets if it is more likely than not that some portion will not be realized, impacting net income
• Deferred taxes do not impact cash flows directly but can provide information about future tax payments or refunds
• Disclosures related to deferred taxes are required, including a reconciliation of the effective tax rate to the statutory rate and the components of deferred tax assets and liabilities
  • This information helps users understand the company's tax position and potential future tax impacts
• Changes in tax rates or laws can have a significant impact on deferred taxes and the financial statements, requiring adjustments and additional disclosures
• The presentation of deferred taxes on the financial statements can impact financial ratios and metrics, such as the debt-to-equity ratio and return on assets

Common Examples

• Depreciation differences: Accelerated tax depreciation methods (MACRS) result in a deferred tax liability, as the tax deduction is taken earlier than the book expense
  • When the asset is fully depreciated, the temporary difference reverses, and the deferred tax liability is reduced
• Accrued expenses: Expenses accrued for book purposes (vacation pay) before they are deductible for tax purposes create a deferred tax asset
  • When the expense is paid and becomes deductible for tax purposes, the temporary difference reverses, and the deferred tax asset is reduced
• Revenue recognition: Differences in the timing of revenue recognition between book and tax (installment sales) can result in deferred tax assets or liabilities
  • As the revenue is recognized for tax purposes, the temporary difference reverses
• Net operating losses (NOLs): NOLs generate a deferred tax asset, as they represent future tax deductions
  • When the NOLs are utilized to offset taxable income, the deferred tax asset is reduced
• Valuation allowances: If a company determines that it is more likely than not that some portion of a deferred tax asset will not be realized, a valuation allowance is recorded
  • This can occur when a company has a history of losses or expects future losses
• Business combinations: Acquisitions can result in temporary differences related to the step-up in the tax basis of assets, creating deferred tax assets or liabilities
  • These differences will reverse as the assets are amortized or sold

Tax Planning Strategies

• Tax planning strategies can be used to manage the timing and amount of deferred taxes, as well as to minimize the overall tax liability
• Accelerating deductions or deferring income can help to manage the timing of temporary differences and the related deferred taxes
  • This can be achieved through the selection of depreciation methods, revenue recognition policies, or the timing of certain transactions
• Utilizing tax credits and incentives can reduce the current tax liability and generate deferred tax assets
  • Examples include research and development credits, investment tax credits, and job creation incentives
• Structuring transactions to minimize permanent differences can help to reduce the overall tax liability
  • This may involve the use of tax-exempt entities, the selection of appropriate jurisdictions, or the structuring of mergers and acquisitions
• Managing the reversal of temporary differences can help to ensure that deferred tax assets are realized and that deferred tax liabilities are minimized
  • This may involve the timing of asset sales, the utilization of NOLs, or the acceleration of deductible expenses
• Regularly reviewing and updating tax planning strategies is essential to ensure that they remain effective and compliant with changing tax laws and regulations
• Collaboration between tax professionals, financial accountants, and management is crucial for developing and implementing effective tax planning strategies that align with the company's overall financial goals