Calculating Corporate Income Taxes by Deferred Tax Benefits

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  • 0:04 Interperiod Tax Allocation
  • 1:24 Balance Sheet Approach…
  • 6:56 Balance Sheet Presentation
  • 7:59 Current Period Tax…
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Lesson Transcript
Instructor: Michael Eagan

Michael teaches tax, accounting and finance courses and has a law degree, an MBA, and an LL.M in Taxation.

This lesson discusses the derivation of deferred tax assets and deferred tax liabilities (DTAs and DTLs), from temporary differences (''deductible amounts''and ''taxable amounts''), as well as balance sheet presentation and the calculation of deferred tax expense.

Interperiod Tax Allocation

Let's say you're a senior tax manager at a large accounting firm. You and Susan, a junior colleague, previously discussed some of the basics of deferred taxes, notably permanent and temporary differences in GAAP and tax accounting. She'd like to continue that discussion and learn more about deferred tax assets and liabilities and the interperiod tax allocation issue.

As we discussed earlier, GAAP (Generally Accepted Accounting Principles) and US tax principles frequently differ on the accounting for items in the financial statements, and these differences are either (1) permanent and affect the current year only or (2) temporary and affect multiple years. The temporary differences give rise to the interperiod tax allocation issue, which you may recall is the temporary difference between the effects of tax policy on the financial reporting of a business and its normal financial reporting as mandated by an accounting framework like GAAP.

GAAP needs to match the tax effects of financial statement items to the proper period. As we will see, GAAP follows a balance sheet, or asset/liability, approach to deferred taxes.

Balance Sheet Approach of ASC 740

''I'm still not sure how temporary differences create deferred tax assets and liabilities,'' Susan tells you.

''So, let's get into that,'' you respond. ''Temporary differences give rise to either a future tax benefit or a future tax liability. These future benefits and liabilities - or, more specifically, the change - impacts the deferred component of current period income tax expense as well as assets and liabilities on the balance sheet.''

When considering a temporary difference, you explain, four scenarios are possible. It's essential to understand the impact the temporary difference has on GAAP and tax asset basis. Two of the scenarios result in higher GAAP basis in an asset than tax basis, which results in higher future taxable income. These are known as taxable amounts. The other two have the opposite effect: higher tax basis than GAAP basis and lower future taxable income. These are called deductible amounts.

You describe the four scenarios as:

  1. The amount of an income item is higher in the current period under GAAP than the related tax inclusion, resulting in higher GAAP basis in an asset (likely a receivable). As we'll see below, it is assumed that tax will ''catch up'' to GAAP in future years, resulting in higher taxable income in those years. An example is the installment sale method for tax purposes, which generally defers gain on an asset sale. Because GAAP typically records all gain in the year of sale, the installment sale method results in higher taxes in the future as the gain is recognized for tax. GAAP basis in the asset - in this case the related receivable - is higher than tax basis in the receivable (zero in our example because none of it has been earned). This is a future tax liability, and the temporary difference is a taxable amount.
  2. The amount of an expense item for tax purposes is higher in the current year than the GAAP inclusion, resulting in a lower tax basis in an asset than its GAAP basis. This means future tax deductions will be lower than GAAP deductions, resulting in higher taxable income. Using accelerated depreciation for tax purposes, for example, versus straight-line depreciation for GAAP will result in lower future tax depreciation relative to GAAP. Again, here, taxable income will be higher in the future. This, too, is a future tax liability, and the temporary difference a taxable amount.
  3. The amount of an income item for tax is higher than the GAAP inclusion, resulting in a higher tax basis than GAAP basis in an asset. This means future taxable inclusions will be lower, resulting in lower future taxable. Certain income items, for example, are included in taxable income when cash is received, such as advance payments, but included in GAAP income on an accrual basis. In this case, future taxable income will be lower as GAAP ''catches up.'' This is a future tax benefit, and the temporary difference is a deductible amount.
  4. Finally, the amount of a GAAP expense item is higher than in the current period tax deduction, resulting in higher tax basis than GAAP basis. This will result in lower future taxable income when tax ''catches up'' to GAAP. Expenses such as warranty and bad debt expense, for example, are estimated for GAAP purposes in the year of the related sale, but are deductible for tax purposes only actually incurred. This, too, is a future tax benefit and the temporary difference a deductible amount. A carryforward NOL is also in this category, as are situations where GAAP 'impairs' the carrying value of the asset for permanent declines in value. Tax gains or losses are locked into the asset until realization (e.g. a sale), creating higher tax basis in the asset than your GAAP's basis.

You summarize the four scenarios for Susan on your whiteboard. She sees that income's tax GAAP inclusion is higher than GAAP = deductible amount and higher than tax = taxable amount, and expense's GAAP inclusion is higher than GAAP = taxable amount, and higher than tax = deductible amount.

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