A company’s accounting policies (such as depreciation choices, and valuation of assets) can cause differences in taxes reported in financial statements and taxes reported on tax returns. In this lesson&nbsp;“Income Taxes” we will learn about several issues relating to deferred taxes.

Income Taxes

<h3>Introduction</h3>
A company’s accounting policies (such as depreciation choices, and valuation of assets) can cause differences in taxes reported in <a title="Conceptual Framework – Recognition of Elements of Financial Statements" href="https://financetrain.com/conceptual-framework-recognition-of-elements-of-financial-statements/">financial statements</a> and taxes reported on tax returns. In this reading “Income Taxes” we will learn about several issues relating to deferred taxes.
<h3>Accounting Profit Vs. Taxable Income</h3>
A company prepares its accounts and financial statements based on the accounting standards such as US GAAP and IFRS. The accounting profit of a company is the net profit before taxes reported in the income statement. However, there are separate income tax laws and regulations that determine the portion of income that is taxable. This is called the <strong>taxable income</strong> and can significantly differ from the accounting profit. The taxable income forms the basis for the amount of tax the company needs to pay.
<h3>Key Terms</h3>
Let’s review the key terms related to income tax.

<strong>Income tax payable:</strong> This is the tax that the company is required to pay based on the taxable income. The term ‘payable’ means that the tax is yet to be paid and is therefore shown as a liability on the balance sheet.

<strong>Income tax expense:</strong> This is the tax expense recognized in the income statement. It is an aggregate of income tax payable (or recoverable as tax benefit) and changes in deferred tax assets and liabilities.

<strong>Deferred tax assets:</strong> Deferred tax assets arise when the taxable income is higher than accounting profits. Therefore the actual income tax payable is higher that the income tax expense as per financial reports. An excess amount of income tax is paid and the company expects to recover the excess amount paid in future.

<strong><a title="Valuation Lecture 1: Introduction to Valuation" href="https://financetrain.com/valuation-lecture-1-introduction-to-valuation/">Valuation</a> allowance:</strong> This is a reserve created for deferred tax assets based on the probability that these deferred tax assets will be realized in the future.

<strong>Deferred tax liabilities:</strong> Deferred tax liabilities arise when taxable income is lower than accounting profits and therefore the income tax payable is less than the income tax expense calculated based on financial reports. The company expects to eliminate the deficit in future.

<strong>Income tax paid:</strong> This is the actual income tax paid during the period. Income tax paid reduces the income tax payable, which is a liability in the balance sheet.

<strong>Tax base: </strong>Also called tax basis, this is the amount at which an asset or liability is valued for tax purposes. This is different from the carrying value (book value) of the asset or liability.

<strong>Tax loss carry forward:</strong> If a company has loss in one period, it may be used to offset future taxable income, hence the term, tax loss carry forward.

Introduction to Income Tax

A <a title="Accounting: Deferred Income Taxes in Business Combinations" href="https://financetrain.com/accounting-deferred-income-taxes-in-business-combinations/">deferred tax</a> liability is created when the income tax expense reported in the income statement is higher than the tax payable as per the tax returns due to temporary differences. The difference between the two is reported in the balance sheet as a deferred tax liability.

This happens when:
<ul>
	<li>A revenue is recognized in the income statement but not included in the tax returns.</li>
	<li>An expense is tax deductible before it is reported in the income statement.</li>
</ul>
The use of different depreciation methods in tax return and income statement is the most common way a deferred tax liability is created.

A deferred tax asset is created when the tax payable as per the tax returns is higher than the income tax expense reported in the income statement.

This happens when:
<ul>
	<li>A revenue is taxable before it is recognized in the income statement.</li>
	<li>Expenses are reported in the income statement before it becomes tax deductible.</li>
</ul>
Note that the differences are temporary because the taxes will be recoverable or payable at a future date.

The most common items resulting in deferred tax assets are post-employment benefits, warranty expenses, and tax loss carry forwards.

Both deferred tax assets and deferred tax liabilities are expected to reverse in future. Deferred tax liabilities result in a cash outflow while deferred tax assets result in future tax savings.

Since deferred tax liabilities result in a future cash outflow, an analyst must decide on their appropriate treatment by reviewing whether the reversal will actually happen or not. If the reversal is expected, then he may treat it as a liability. However, if reversal is not expected, then for analytical purpose, he should treat this as equity.

Deferred Tax Liabilities and Assets

Tax base is the amount at which an asset or liability is valued for tax purposes.
<h3>Tax Base of Assets</h3>
The following are a few examples of calculating tax bases for various assets.
<table>
<tbody>
<tr>
<td width="130"><strong>Asset</strong></td>
<td width="486"><strong>Calculation of Tax Base</strong></td>
</tr>
<tr>
<td width="130"><strong>Depreciable Equipment</strong></td>
<td width="486">The cost of the equipment: $1,000,000Depreciation is done using straight-line method at 10% per annum, i.e., $100,000 per year.

Depreciation allowed under income tax is 15%.

Carrying value after one year = 900,000 (1,000,000 – 100,000)

Tax base after one year = 850,000 (1,000,000 – 150,000)

Carrying amount is greater than tax base. Due to this difference, a deferred tax liability equal to 50,000 * tax rate is created.</td>
</tr>
<tr>
<td width="130"><strong>Development costs</strong></td>
<td width="486">A company capitalized $1,000,000 of development cost. $200,000 of this amount was amortized during the year.For tax purpose, upto 25% of the amount can be amortized.

Carrying value after one year = 800,000 (1,000,000 – 200,000)

Tax base after one year = 750,000 (1,000,000 – 250,000)</td>
</tr>
<tr>
<td width="130"><strong>Research costs</strong></td>
<td width="486">A company incurred $1,000,000 on research costs. The entire cost was expensed in the current year.The tax laws allow research cost to be expensed over a 5-year period.

The carrying amount = $0.

Tax base = 1,000,000 – (1,000,000/5) = $800,000

This leads to the creation of a deferred tax asset as taxable income is higher than earnings before tax.</td>
</tr>
<tr>
<td width="130"><strong> Accounts receivable</strong></td>
<td width="486">The company has a provision for doubtful debt = $100,000Accounts receivable after adjusting for provision = $1,000,000

Tax laws allow a 25% deduction for doubtful debt on gross receivables.

Accounts receivable before provision of doubtful debt = $1,000,000 + 100,000 = $1,100,000

Tax base = 1,100,000 * (25% of 1,100,000) = 82,5000

This leads to the creation of a deferred tax liability.</td>
</tr>
</tbody>
</table>
<h3></h3>
<h3>Tax Bases of Liabilities</h3>
The following are a few examples of calculating tax bases for various liabilities.
<table>
<tbody>
<tr>
<td width="130"><strong>Liability</strong></td>
<td width="486"><strong>Calculation of Tax Base</strong></td>
</tr>
<tr>
<td width="130"><strong>Advance paid by customer</strong></td>
<td width="486">A customer has paid an advance amount of $100,000 but the product will be delivered only in the next financial year.Tax laws require advance revenue to be taxable when collected.

Advance revenue will be a liability with a carrying value of $100,000.

Tax base will be zero because the entire amount has been taxed in the year in which the advance is received and it will not be taxed in the future.

This will lead to the creation of a deferred tax asset because the amount is taxed but the revenue is not reported in the income statement.</td>
</tr>
<tr>
<td width="130"><strong>Donations</strong></td>
<td width="486">A company received donations worth $100,000 in the current period. The donations were expensed in the income statement.According to the tax laws, donations are not tax-deductible.

The carrying value = $0 since entire amount is expensed.

Tax base equals the carrying amount since the donations are not tax-deductible.

Though the amounts are same, the treatment for accounting and taxation is different. This results in a permanent difference.</td>
</tr>
<tr>
<td width="130"><strong>Loan</strong></td>
<td width="486">A company secured a loan of $100,000 in the current period. Interest on loan is 12% per annum payable at the end of each year.There are no tax implications for loan repayment. The interest paid is treated in the same way for both accounting and taxation.

The tax base and carrying value will be $0.</td>
</tr>
<tr>
<td width="130"><strong>Advance rent received</strong></td>
<td width="486">A company receives advance rent of $100,000. The amount is deferred for tax purpose but taxed on a cash basis.The carrying amount of the advance rent received will be $100,000. It is a balance sheet liability and the income relates to future financial year.

The tax base will be $0 as the entire amount is taxed in the current period.</td>
</tr>
</tbody>
</table>

Tax Base of Assets and Liabilities

We have the following information about an asset of a company.

Original cost: $1,500,000

Useful life of the asset: 3 years

Salvage value: $0

<a title="Impact of Depreciation Methods on Financial Statements" href="https://financetrain.com/impact-depreciation-methods-financial-statements/">Depreciation</a> for accounting purpose: $500,000 per year using straight line method

Depreciation for taxation purpose: $600,000 in year 1, $500,000 in year 2, and $400,000 in year 3.

<a title="Calculation of EBITDA Under IFRS" href="https://financetrain.com/calculation-of-ebitda-under-ifrs/">EBITDA</a>: $1,000,000

Tax rate: 40%

We can calculate the firm’s income tax expense, taxes payable, and deferred tax liability as follows:
<h3><strong>Income Statement</strong></h3>
<table>
<tbody>
<tr>
<td width="154"><strong> </strong></td>
<td width="154"><strong>Year 1</strong></td>
<td width="154"><strong>Year 2</strong></td>
<td width="154"><strong>Year 3</strong></td>
</tr>
<tr>
<td width="154"><strong>EBITDA</strong></td>
<td width="154">1,000,000</td>
<td width="154">1,000,000</td>
<td width="154">1,000,000</td>
</tr>
<tr>
<td width="154"><strong>Depreciation</strong></td>
<td width="154">$500,000</td>
<td width="154">$500,000</td>
<td width="154">$500,000</td>
</tr>
<tr>
<td width="154"><strong>Income before tax</strong></td>
<td width="154">500,000</td>
<td width="154">500,000</td>
<td width="154">500,000</td>
</tr>
<tr>
<td width="154"><strong>Income tax expense</strong></td>
<td width="154">200,000</td>
<td width="154">200,000</td>
<td width="154">200,000</td>
</tr>
</tbody>
</table>
&nbsp;

<strong>Income Tax Returns</strong>
<table>
<tbody>
<tr>
<td width="154"><strong> </strong></td>
<td width="154"><strong>Year 1</strong></td>
<td width="154"><strong>Year 2</strong></td>
<td width="154"><strong>Year 3</strong></td>
</tr>
<tr>
<td width="154"><strong>EBITDA</strong></td>
<td width="154">1,000,000</td>
<td width="154">1,000,000</td>
<td width="154">1,000,000</td>
</tr>
<tr>
<td width="154"><strong>Depreciation</strong></td>
<td width="154">$600,000</td>
<td width="154">$500,000</td>
<td width="154">$400,000</td>
</tr>
<tr>
<td width="154"><strong>Income before tax</strong></td>
<td width="154">400,000</td>
<td width="154">500,000</td>
<td width="154">600,000</td>
</tr>
<tr>
<td width="154"><strong>Tax payable</strong></td>
<td width="154">160,000</td>
<td width="154">200,000</td>
<td width="154">240,000</td>
</tr>
</tbody>
</table>
In year 1, income tax expense is $200,000 but the tax payable is only $160,000. The difference of $40,000 is deferred to future period and reported on balance sheet as Deferred Tax Liability (DTL).

In year 2, depreciation is same for both accounting and tax purpose; therefore, income tax expense and tax payable are same. There will be no change in DTL.

In year 3, tax payable is higher than income tax expense by $40,000. The Deferred Tax Liability recognized at the end of year 1 will now be reversed.

Note that over the period of three years, the income tax expense, tax payable, and the total depreciation are same for both income statement and tax returns.
<h3>Impact of Tax Rate Change on Financial Statements</h3>
If the income tax rates change, the firm is required to adjust the values of deferred tax assets and liabilities to reflect the new tax rate. The income tax expense may also be affected.

If tax rate increases:
<ul>
	<li>Deferred tax assets and liabilities increase</li>
	<li>Income tax expense = Income tax payable + &delta;DDTL – D DTA</li>
</ul>
If tax rate decreases:
<ul>
	<li>Deferred tax assets and liabilities decrease</li>
	<li>Income tax expense = Income tax payable - DDTL + D DTA</li>
</ul>
<h5>Example</h5>
A firm has an asset with carrying value = $500,000

Tax base = $400,000

Tax rate = 40%

Deferred Tax Liability = 40% * (500,000 – 400,000) = $40,000

Bad debt expense recognized in income statement = $25,000. Carrying value is $0.

This bad debt expense is not deducted in tax returns. Tax base is $25,000

Deferred Tax Asset = 40% * (25,000 – 0) = $10,000

The tax rate changes to 30%.

Since the tax rate has decreased, both DTL and DTA will decrease.

New DTL = 30% * (500,000 – 400,000) = $30,000. DTL is lower by $10,000

New DTA = 30% * (25,000 – 0) = $7,500. DTA is lower by $2,500.

We will apply the following equation to determine the change in income tax expense:

Income tax expense = Income tax payable - DDTL + D DTA

The income tax expense will reduce by $7,500.

Example of a Deferred Tax Liability

A <strong>permanent difference</strong> between taxable income and accounting profits results when a revenue (gain) or expense (loss) enters book income but never recognized in taxable income or vice versa. The difference is permanent as it does not reverse in the future. Thus, book and tax will never equalize.

These differences do not result in the creation of a deferred tax. Instead of creating a deferred tax asset or liability, the permanent difference results in a difference between the company’s effective tax rate and the statutory tax rate.

Effective tax rate = Income tax expense/Pre-tax income

Some examples of permanent differences are: Fines and Penalties, Meals and Entertainment, Political Contributions, Officers Life Insurance, and Tax-exempt Interest.

A temporary difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period. A temporary difference is expected to reverse in the future and therefore results in the creation of a DTL or DTA. The following are some examples of temporary differences and DTL/DTA created.
<table width="631">
<tbody>
<tr>
<td width="151"><strong>Event</strong></td>
<td width="142"><strong>Book Income</strong></td>
<td width="132"><strong>Tax Income</strong></td>
<td width="92"><strong>Def. Tax Asset</strong></td>
<td width="113"><strong>Def. Tax Liability</strong></td>
</tr>
<tr>
<td width="151">Installment Sales</td>
<td width="142">Revenue Today</td>
<td width="132">Income Later</td>
<td width="113">Yes</td>
</tr>
<tr>
<td width="151">Product Warranties</td>
<td width="142">Expense Today</td>
<td width="132">Deduction Later</td>
<td width="92">Yes</td>
</tr>
<tr>
<td width="151">Bad Debt Expense</td>
<td width="142">Expense Today</td>
<td width="132">Deduction Later</td>
<td width="92">Yes</td>
</tr>
<tr>
<td width="151">Rent Rec’d in Advance</td>
<td width="142">Revenue Later</td>
<td width="132">Income Today</td>
<td width="92">Yes</td>
</tr>
<tr>
<td width="151">Depreciation Expense</td>
<td width="142">Straight-Line</td>
<td width="132">Accelerated</td>
<td width="113">Yes</td>
</tr>
<tr>
<td width="151">Prepaid Expenses</td>
<td width="142">Expense Later</td>
<td width="132">Deduction Today</td>
<td width="113">Yes</td>
</tr>
<tr>
<td width="151">Impairment</td>
<td width="142">Expense Today</td>
<td width="132">Deduction Later</td>
<td width="92">Yes</td>
<td width="113"></td>
</tr>
</tbody>
</table>
Note that a Deferred Tax Liability is created when Future Taxable Income &gt; Future Book Income. A Deferred Tax Asset is created when Future Taxable Income &lt; Future Book Income.

The following table summarizes how differences in carrying amount and tax base result in creation of DTL and DTA.
<table>
<tbody>
<tr>
<td width="205"><strong>Balance Sheet Item</strong></td>
<td width="205"><strong>Carrying Amount Vs. Tax Base</strong></td>
<td width="205"><strong>Result</strong></td>
</tr>
<tr>
<td width="205"><strong>Asset</strong></td>
<td width="205">Carrying Amount &gt; Tax Base</td>
<td width="205">Deferred tax liability</td>
</tr>
<tr>
<td width="205"><strong>Asset</strong></td>
<td width="205">Carrying Amount &lt; Tax Base</td>
<td width="205">Deferred tax asset</td>
</tr>
<tr>
<td width="205"><strong>Liability</strong></td>
<td width="205">Carrying Amount &gt; Tax Base</td>
<td width="205">Deferred tax asset</td>
</tr>
<tr>
<td width="205"><strong>Liability</strong></td>
<td width="205">Carrying Amount &lt; Tax Base</td>
<td width="205">Deferred tax liability</td>
</tr>
</tbody>
</table>
Temporary differences can be of two types:
<ul>
	<li>Taxable temporary differences: These differences result in future taxable income.</li>
	<li>Deductible temporary differences: These differences result in future tax deductions.</li>
</ul>

Permanent and Temporary Differences Between Taxable Income and Accounting Profits

A deferred tax asset is created due to a temporary difference between accounting profits and taxable income and the company expects this difference to reverse in the future with sufficient future taxable income. However, if there is not sufficient taxable income in the future, the DTA cannot be reversed.

For this reason, the company is required to assess every year, the likelihood that there will be sufficient future taxable income which will be used to recover the tax asset. Under US GAAP, if there is a &gt;50% probability that DTA will not be realized, then the company is required to create a valuation allowance to reduce the deferred tax asset.

When a valuation allowance is recognized, there is a corresponding reduction in DTA, increase in income tax expense, and decrease in net income.

If it is subsequently determined that the deferred tax benefit will be realized, then the entry that established the valuation allowance is reversed. This results in a decrease in income tax expense and an increase in net income. Some analysts call this cookie jar accounting.

Note that valuation allowance is used only for DTA. US GAAP does not allow netting of DTA and DTL.

An analyst must scrutinize valuation allowances as a company may use it to manipulate earnings.

Valuation Allowance for Deferred Tax Assets

The following information about the deferred tax items is usually disclosed:
<ul>
	<li>Total of all deferred tax liabilities ($48 million in our Illustration 16-10 Note).</li>
	<li>Total of all deferred tax assets ($26 million in our Illustration 16-10 Note).</li>
	<li>Total valuation allowance recognized for deferred tax assets.</li>
	<li>Net change in the valuation allowance.</li>
	<li>Approximate tax effect of each type of temporary difference (and carry forward).</li>
	<li>Tax loss carry forwards</li>
	<li>Reconciliation between the federal statutory and effective tax rates</li>
	<li>Components of deferred tax expense (e.g., revenue and expense items that cause the deferred tax expense, assets, liabilities, such as depreciation, bad debts, installment sales, etc.)</li>
</ul>
<strong>Reconciliation of Effective Tax Rate</strong>

We learned that a firm’s income tax expense can differ from the amount of tax paid based on the statutory tax rate. The tax rate paid by the company is the effective tax rate calculated as follows:

Effective tax rate (ETR) = Income tax expense/Pre-tax income

An analyst can reconcile the two rates which will help him identify the reasonableness of the effective tax rate and also compare ETR with the statutory tax rate.

Some of the common reconciling items are:
<ul>
	<li>Non-deductible expenses (Permanent Differences)</li>
	<li>Rate adjustments</li>
	<li>Change in valuation allowance</li>
	<li>Difference in future income tax rates</li>
	<li>Tax rate changes</li>
	<li>Adjustments to<a title="Why do companies manipulate their financial reports?" href="https://financetrain.com/why-do-companies-manipulate-their-financial-reports/"> tax reserves</a></li>
	<li>Adjustments to prior year amounts</li>
</ul>
<strong>Example</strong>

Net income before taxes is $125,000. Tax expense is $52,700. Statutory rate is 36%. Tax reserves were increased by $5,000. Non-temporary add-backs were estimated at $10,000. Total temporary differences at the beginning of the year were $45,000, resulting in future tax liabilities of $16,000. Tax rates used for future taxes decreased by 2% during the year.

The following table summarizes the reconciliation:
<table>
<tbody>
<tr>
<td width="205"><strong>Net Income</strong></td>
<td width="205"><strong>$125,000</strong></td>
<td width="205"><strong> </strong></td>
</tr>
<tr>
<td width="205"><strong>Statutory rate</strong></td>
<td width="205">45,000</td>
<td width="205">36%</td>
</tr>
<tr>
<td width="205"><strong>Tax rate changes</strong></td>
<td width="205">(900)</td>
<td width="205">(0.72%)</td>
</tr>
<tr>
<td width="205"><strong>Change in tax reserves</strong></td>
<td width="205">5,000</td>
<td width="205">4%</td>
</tr>
<tr>
<td width="205"><strong>Non-deductible expenses</strong></td>
<td width="205">3,600</td>
<td width="205">2.88%</td>
</tr>
<tr>
<td width="205"><strong>Effective rate</strong></td>
<td width="205"><strong>$52,700</strong></td>
<td width="205"><strong>42.16%</strong></td>
</tr>
</tbody>
</table>

Disclosures for Deferred Tax Items

Even though <a title="Calculation of EBITDA Under IFRS" href="https://financetrain.com/calculation-of-ebitda-under-ifrs/">IFRS</a> and US <a title="Accrual Accounting Concept in IFRS and GAAP" href="https://financetrain.com/accrual-accounting-concept-in-ifrs-and-gaap/">GAAP</a> have similar treatment of income tax issues, there are some <a title="Differences in IFRS and US GAAP Frameworks" href="https://financetrain.com/differences-in-ifrs-and-us-gaap-frameworks/">differences</a>. These differences are summarized below:
<table>
<tbody>
<tr>
<td width="205"><strong> </strong></td>
<td width="205"><strong>US GAAP</strong></td>
<td width="205"><strong>IFRS</strong></td>
</tr>
<tr>
<td width="205"><strong>Recognition of deferred tax assets</strong></td>
<td width="205">Recognized in full (except for certain outside basis differences), but valuation allowance reduces asset to the amount that is more likely than not to be realized.</td>
<td width="205">Amounts are recognized only to the extent it is probable (similar to ―more likely than not under US GAAP) that they will be realized.</td>
</tr>
<tr>
<td width="205"><strong>Calculation of deferred</strong><strong>tax asset or liability</strong></td>
<td width="205">Enacted tax rates must be used.</td>
<td width="205">Enacted or ―substantively enacted tax rates as of the balance sheet date must be used.</td>
</tr>
<tr>
<td width="205"><strong>Classification of deferred</strong><strong>tax assets and liabilities</strong><strong>in balance sheet</strong></td>
<td width="205">Current or non-current classification, based on the nature of the related asset or liability, is required.</td>
<td width="205">All amounts classified as non-current in the balance sheet.</td>
</tr>
<tr>
<td width="205"><strong>Recognition of deferred</strong><strong>tax liabilities from</strong><strong>investments in</strong><strong>subsidiaries or joint</strong>

<strong>ventures (JVs) (often</strong>

<strong>referred to as outside</strong>

<strong>basis differences)</strong></td>
<td width="205">Recognition not required for investment in a foreign subsidiary or corporate JV that is essentially permanent in duration, unless it becomes apparent that the difference will reverse in the foreseeable future.</td>
<td width="205">Recognition required unless the reporting entity has control over the timing of the reversal of the temporary difference and it is probable (―more likely than not) that the difference will not reverse in the foreseeable future.</td>
</tr>
<tr>
<td width="205"><strong>Revaluation of fixed assets</strong><strong>and intangible assets</strong></td>
<td width="205">Not applicable, no revaluation allowed.</td>
<td width="205">Deferred taxes are recognized in equity.</td>
</tr>
</tbody>
</table>

Accounting for Income Taxes

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