Investment Management

Management 220

Deferred Taxes Summary of Key Points

Summary of Key Points

1. INCOME TAX EXPENSE, AS REPORTED IN THE INCOME STATEMENT, REFLECTS NOT ONLY CURRENT AMOUNTS OWED VARIOUS TAXING AUTHORITIES (FEDERAL, STATE, AND FOREIGN), BUT THE ESTIMATED FUTURE TAX CONSEQUENCES OF CURRENT TRANSACTIONS

        How should financial statements reflect the impact of differences between GAAP and the tax rules as to when certain revenues and expenses are recognized?  Should income tax expense simply reflect the current liability owed taxing authorities and ignore the future tax consequences of current period transactions?  Should income tax expense be measured as though the pre-tax book profit were actually equal to taxable income, with any difference “plugged” to a deferred tax account on the balance sheet? Over the years, several approaches have been proposed (and even implemented) to answer this question.

        Current GAAP (FAS 109) requires that tax expense, as reported in the income statement, reflect not only amounts currently owed various taxing authorities (federal, state, and foreign), but the estimated future tax consequences of all current transactions.  Therefore, if future taxes will likely be paid as a result of a transaction from the current year, the current period income statement should include this “deferred” cost/liability as a component of income tax expense.  More generally, income tax expense will include the change during the period in the cumulative tax-effected timing differences between book income and taxable income.

1. FOUR TYPES OF TIMING DIFFERENCES CREATE DEFERRED TAXES  

Given the requirements of FAS 109, there are four types of “timing” differences that result in deferred tax assets or liabilities:

• Revenues are recognized earlier for taxes than for books (e.g. prepaid rents, prepaid subscriptions) resulting in deferred tax assets.
• Revenues are recognized earlier for books than for taxes (e.g. percentage of completion or installment sales) resulting in deferred tax liabilities.
• Expenses are recognized earlier for taxes than for books (e.g. accelerated depreciation, goodwill) resulting in deferred tax liabilities.
• Expenses are recognized earlier for books than for taxes (e.g. bad debt expenses and other reserves) resulting in deferred tax assets.

To avoid confusion as to whether a timing difference results in a deferred tax asset or liability, the answer to the question, “will the particular timing difference increase or decrease future taxes?” should clarify the uncertainty.  Deferred tax assets result in lower future taxes and vice-versa.  Remember that “permanent” differences, representing those situations in which there is never a tax consequence resulting from a transaction reflected in the financial statements (e.g. municipal bond income, life insurance proceeds and premiums, 50% of meals and entertainment), do not result in any deferred taxes.