18.1 Deferred Taxes and ASC 740

Deferred Taxes and ASC 740

Under US GAAP, ASC 740 (Income Taxes) governs how companies account for and report income taxes in their financial statements. The core objective of ASC 740 is to recognize the amount of current and deferred taxes payable or refundable at the date of the financial statements. It uses an asset and liability approach, meaning that deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are recognized on the balance sheet for the estimated future tax consequences of events that have been recognized in the financial statements or tax returns.

The Accrual Matching Concept for Taxes

Financial statements are prepared using the accrual basis of accounting under GAAP, whereas tax returns are prepared based on tax laws (Internal Revenue Code or IRC) which often emphasize cash flows or specific fiscal policy incentives. This misalignment creates differences between the pretax financial income (book income) reported on the income statement and the taxable income reported on the tax return. To adhere to accrual principles, ASC 740 requires companies to calculate and recognize the deferred tax consequences of these differences, rather than simply recording the current tax payable as the tax expense.

Temporary vs. Permanent Differences

The differences between book income and taxable income fall into two categories: temporary differences and permanent differences. Understanding this distinction is critical for CPA FAR candidates.

1. Temporary Differences

Temporary differences are differences between the GAAP carrying amount of an asset or liability on the balance sheet and its tax basis (its value for tax purposes) that will result in taxable or deductible amounts in future years when the asset is recovered or the liability is settled.

• Taxable Temporary Differences (Deferred Tax Liabilities - DTLs): These are differences that will result in taxable amounts in future years when the related asset or liability is recovered or settled. They arise when GAAP income is recognized before tax income, or tax deductions are taken before GAAP expenses. They represent future taxable amounts, creating a deferred liability.
  • Accelerated Depreciation: Using straight-line depreciation for GAAP but MACRS (accelerated) depreciation for tax returns. This is the most common DTL trigger on the CPA exam.
  • Installment Sales: Recognizing revenue at the point of sale for GAAP but when cash is collected for tax.
  • Prepaid Expenses: Deducting prepaid expenses (e.g., rent, insurance) when paid for tax purposes but amortizing them over time for GAAP.
• Deductible Temporary Differences (Deferred Tax Assets - DTAs): These are differences that will result in deductible amounts in future years when the related asset or liability is recovered or settled. They arise when tax income is recognized before GAAP income, or GAAP expenses are recognized before tax deductions. They represent future tax savings, creating a deferred asset.
  • Warranty Liabilities: Expensing estimated warranties when the sale occurs for GAAP but deducting only actual warranty expenditures when paid for tax.
  • Bad Debt Expense (CECL/Allowance): Recording bad debt expense based on expected losses under GAAP (allowance method) but deducting bad debts only when they are written off (direct write-off method) for tax.
  • Unearned Revenue: Taxing customer advances when cash is received but deferring revenue until earned for GAAP.

2. Permanent Differences

Permanent differences are items that enter into financial income or taxable income, but never both. They do not reverse in future periods and, therefore, do not give rise to deferred tax assets or liabilities. Instead, they directly affect the company's effective tax rate for the current period.

• Interest income on municipal bonds: Exempt from federal income tax but recognized as income under GAAP.
• Life insurance proceeds: Received by the corporation upon the death of a key officer (not taxable under tax laws but income under GAAP).
• Premiums paid on key-man life insurance policies: Not deductible for tax purposes but expensed under GAAP.
• Fines and penalties: Paid to government entities for law violations (not deductible for tax but expensed under GAAP).
• Nondeductible entertainment expenses: Expensed for GAAP but disallowed for tax.

Deferred Tax Calculations and the Enacted Rate

Deferred tax assets and liabilities are calculated by multiplying the cumulative temporary differences by the enacted tax rate that is expected to apply to taxable income in the periods in which the temporary differences are expected to reverse.

[!IMPORTANT] Under GAAP, companies must use the enacted tax rate, not the effective tax rate, and not the proposed or anticipated tax rate. A tax rate change is not recognized in the financial statements until the date the tax law is officially enacted (signed into law) by the legislative body.

Accounting for Tax Rate Changes

When tax laws change and a new tax rate is enacted, all existing DTAs and DTLs must be revalued to reflect the new rate. The effect of this revaluation is a change in the deferred tax balances and must be recognized in the income statement as a component of income tax expense from continuing operations in the period of enactment.

For example, if a company has a DTL of $21,000 based on a 21% tax rate, and a new law is enacted raising the rate to 25%, the company must adjust the DTL to $25,000. The $4,000 adjustment is recorded as follows:

Debit: Income Tax Expense (Deferred)     $4,000
  Credit: Deferred Tax Liability                  $4,000

This adjustment occurs in the period of enactment, even if the new rate does not take effect until a future year.

Presentation on the Balance Sheet

Under GAAP (ASU 2015-17), all deferred tax assets and liabilities must be classified as noncurrent on the balance sheet. They are not split into current and noncurrent portions. Furthermore, DTAs and DTLs in the same tax jurisdiction must be netted and presented as a single net noncurrent asset or liability.

Comprehensive Calculation Example

For the year ended December 31, Year 1, Alpha Corporation reports pretax financial income of $800,000. The following information is available:

1. Municipal bond interest income of $30,000 was received during the year.
2. GAAP depreciation expense was $100,000, while MACRS tax depreciation was $160,000.
3. Estimated warranty expense recorded under GAAP was $40,000. No actual warranty costs were paid during the year.
4. The enacted tax rate for Year 1 is 21%. A tax law was enacted in Year 1 changing the rate to 25% for Year 2 and subsequent years.

Step 1: Reconcile Pretax Financial Income to Taxable Income

• Pretax Financial Income: $800,000
• Less: Municipal interest (Permanent difference): ($30,000)
• Less: Excess tax depreciation ($160k tax - $100k GAAP) (Temporary difference, taxable): ($60,000)
• Add: Warranty expense (Temporary difference, deductible): $40,000
• Taxable Income: $750,000

Step 2: Calculate Current Income Tax Expense

• Current Tax Payable = Taxable Income * Current Enacted Rate (21%)
• Current Tax Payable = $750,000 * 21% = $157,500

Step 3: Calculate Deferred Tax Balances at Year-End

We use the newly enacted rate of 25% because these differences will reverse in future years when the 25% rate is in effect.

• Deferred Tax Liability (Depreciation): $60,000 * 25% = $15,000
• Deferred Tax Asset (Warranty): $40,000 * 25% = $10,000
• Deferred Tax Expense (Benefit) = Change in DTL - Change in DTA
• Deferred Tax Expense = $15,000 - $10,000 = $5,000

Step 4: Record the Journal Entry at December 31, Year 1

Debit: Income Tax Expense (Current)    $157,500
Debit: Deferred Tax Asset                $10,000
  Credit: Income Tax Payable                     $157,500
  Credit: Deferred Tax Liability                  $15,000

Total Income Tax Expense reported on the Income Statement:

• Current portion: $157,500
• Deferred portion: $5,000 ($15,000 deferred expense - $10,000 deferred benefit)
• Total Income Tax Expense = $162,500