Understanding Deferred Tax Assets and Deferred Tax Liabilities (Video Link)
The concept of deferred taxes is one of the most difficult accounting concepts to understand.
This post explains some of the basic concepts you need to know to work with this accounting issue. For a comprehensive explanation using spreadsheets, watch one of my YouTube videos on the subject. If you’d like a copy of the spreadsheet used to create the video, email me at ken@stltest.net, and I’ll send it to you.
OK- the basic concepts, using a business example.
What’s a temporary difference?
Book (accounting) income is not always equal to the income your business reports on the tax return.
Differences can be permanent, meaning that book income will never equal tax income.
A good example is tax-exempt income on municipal bonds. Assume, for example, that a company owns $50,000 in state-issued municipal bonds and earns $2,500 in interest income during the year.
The accounting records will include $2,500 in interest income as non-operating income, but the tax income will exclude the $2,500 from taxes. The business tax return will include a reconciliation from book income to taxable income, and the $2,500 in municipal bond interest income will be a reconciling item.
As the name implies, temporary differences eventually go away- and there is no long-term difference between your accounting income and tax income. The difference is only in the timing of a particular income or expense item.
Temporary differences may generate deferred tax asset and/ or deferred tax liability balances.
Temporary difference: An example
The most common temporary difference is due to depreciation expense, because the tax laws may record annual depreciation expense differently than in the accounting records. Here’s an example of a temporary difference due to depreciation:
Denney Plumbing buys a new plumbing truck for $30,000, and the company determines that the truck’s useful life is five years. The truck is depreciated on a straight-line basis, meaning that Denney will recognize $6,000 of annual depreciation on the truck ($30,000 cost / 5 year useful life).
Assume that current tax laws allow Denney to depreciate the truck at a rate of $10,000 a year for three years. In year one, depreciation expense for taxes will be $4,000 higher than depreciation expense in the accounting records ($10,000 - $6,000). The $4,000 is a temporary difference, and it creates a deferred tax liability.
A key point to remember is that total depreciation for both book income and tax income is the same. Both methods post total truck depreciation expense of $30,000, and the only difference is in the timing of the expense each year.
How a deferred tax liability is generated
While Denney has more depreciation expense and a lower tax liability in year one, the company will have less depreciation expense and a higher tax liability in later years. Specifically, Denney will not have any tax depreciation expense for the truck in years four and five, because the entire cost of the truck ($30,000) is depreciated in years one to three. Denney has a deferred tax liability, due to higher taxes paid in future years.
Posting accounting entries
Assume that Denney’s net income in year one is $500,000, less the $10,000 in tax depreciation, or $490,000. Assuming a 20% tax rate, Denney’s taxes payable is $98,000. This is the amount Denney pays in taxes for year one.
Denney also calculates the tax impact of the temporary difference, which is the $4,000 difference at the 20% tax rate. The deferred tax liability for year one is ($10,000 - $6,000) X 20% = $800.
Finally, Denney’s income tax expense is the sum of the taxes payable ($98,000), plus the deferred tax liability ($800), or a total of $98,800.
The company must calculate the taxes payable and the tax impact of temporary differences each year. A large firm may have dozens of temporary differences each year, so the calculation may be complicated.
Reviewing a deferred tax asset
A deferred tax asset means that the business has more expenses and a lower tax liability in later years. If, for example, the truck had less tax depreciation in the early years and more tax deprecation expense in later years, the company would have a deferred tax asset, due to a lower future tax liability.
You can watch a comprehensive example of deferred tax assets and deferred tax liabilities here. Email me at ken@stltest.net for the spreadsheet.
Good luck!