COMPANY’S INCOME TAX PROVISION
Step 4: Determine the Ending Balances in the Balance Sheet Deferred Tax Asset and Liability Accounts
The FASB could have decided that a company should report only the “as paid”
income taxes on its income statement. Investors and policy makers might favor this approach because it would disclose the actual income taxes paid or refunded (cash out- flow or inflow) in the current year. However, reporting only income taxes currently pay- able ignores one of the basic premises underlying financial accounting, which is that the accrual method of accounting provides more relevant information to investors and credi- tors than the cash method of accounting.23
The deferred income tax expense or benefit portion of a company’s income tax provi- sion reflects the change during the year in a company’s balance sheet deferred tax liabili- ties or assets.24 This information provides investors and other interested parties with a measure of a company’s expected future income-tax-related cash inflows or outflows re- sulting from book–tax differences that are temporary in nature or from tax carryovers.
ASC 740 takes an asset and liability or balance sheet approach to the computation of the deferred tax expense or benefit. The computations are based on the change in the differences between the financial accounting (book) adjusted basis of an asset or liabil- ity and its corresponding adjusted tax basis from the beginning of the year to the end of the year. Under GAAP, the company is presumed to recover these basis differences over time, resulting in future sacrifices of a company’s resources (in the case of liabilities) or future recoveries of a company’s resources (in the case of assets). These expected future recoveries of assets or future sacrifices of assets to settle liabilities give rise to future (deferred) tax payments or refunds that are recorded in the income tax provision in the year the differences arise rather than in the year in which the future taxes are paid or recovered.
The future tax cost of a taxable (cumulatively favorable) temporary difference is re- corded on the balance sheet as a deferred tax liability. The company computes the de- ferred tax liability using the enacted tax rate that is expected to apply to taxable income in the period(s) in which the deferred tax liability is expected to be settled.25
continued from page 17-6 . . .
Having calculated the current portion of PCC’s income tax provision, Elise turned her attention to computing the deferred component of PCC’s income tax provision. She knew from training that the technically correct method to compute PCC’s deferred tax provision is to compare the financial accounting (book) basis of each asset and liability with its corresponding tax basis. Elise had the financial accounting basis of each account from the balance sheet, but like many companies, PCC did not keep a formal tax accounting balance sheet.22 Elise would need to use an alternate method to calculate the change in the adjusted book–tax basis differences for each account she identified as being a temporary difference.
22Schedule L to Form 1120 requests that the taxpayer report its financial statement balance sheet. An increasing number of corporations are finding that a “best practice” is to maintain a tax basis balance sheet separate from the financial accounting balance sheet.
23ASC 230, Statement of Cash Flows, requires an enterprise to separately disclose income taxes paid as part of the statement itself or in a note to the financial statements (usually the income taxes note or a supplemental cash flow note).
24ASC 740-10-20 Glossary.
25ASC 740-10-30-2. For federal income tax provision purposes, a corporation applies the regular tax rate in computing its deferred tax assets and liabilities. The alternative minimum tax credit carryforward is treated as a prepaid income tax and is reported as a deferred tax asset on the balance sheet.
Example 17-6
Lacking a formal tax-basis balance sheet, Elise identified the current-year temporary differences and adjusted (“rolled forward”) the cumulative differences at the beginning of the year to get the end-of-the-year adjusted book–tax basis differences. She used this change in the adjusted book–
tax basis difference to compute the deferred tax expense or benefit for the current year. Elise re- viewed her schedules of favorable and unfavorable temporary differences (from Example 17-4).
She identified one favorable temporary difference related to an asset recorded on the balance sheet—the excess of tax depreciation over book depreciation. Elise retrieved the fixed asset work- papers and recorded the changes in the financial accounting and tax accumulated depreciation balances of PCC’s fixed assets from the beginning of the year to the end of the year related to current-year depreciation.
Financial accounting change in accumulated depreciation*
Beginning of the year $12,000,000
End of the year 14,400,000
Net change $ 2,400,000
Tax accounting change in accumulated depreciation*
Beginning of the year $22,000,000
End of the year 25,100,000
Net change $ 3,100,000
*Not given in the original facts; assumed for purposes of this example.
The net increase in tax accounting accumulated depreciation over the corresponding financial accounting depreciation created a current-year $700,000 favorable (taxable) temporary difference (i.e., the cumulative difference between the financial accounting basis of the fixed assets increased by
$700,000 over its corresponding tax basis). This increase in the cumulative favorable temporary differ- ence requires an increase in PCC’s deferred tax liabilities.
By what amount will PCC increase its deferred tax liabilities as a result of the increase in the adjusted book basis over the adjusted tax basis in these assets from the beginning of the year to the end of the year?
Answer: $147,000, computed as $700,000 × 21 percent.
What tax accounting journal entry does PCC record related to this transaction?
Answer:
Deferred income tax expense 147,000
Deferred income tax liability 147,000
What if: Assume current-year book depreciation exceeded current-year tax depreciation by
$700,000. What adjustment to the balance sheet would PCC be required to make?
Answer: PCC would decrease its deferred tax liability on the balance sheet by $147,000.
Example 17-7
Elise also saw that accumulated depreciation decreased as a result of PCC’s sale of a fixed asset dur- ing the year (see Exhibit 17-3). She observed from the workpapers that PCC sold the fixed asset for
$100,000, its original cost (not given in the original facts, assumed for purposes of this example). The book basis of the asset was $46,000, resulting in a book gain of $54,000. The tax gain on the sale was $70,000, which corresponds to a decrease in accumulated tax depreciation of $70,000 (i.e., the tax basis of the asset was $30,000). The excess of the reduction in accumulated tax depreciation over (continued on page 17-14 )
accumulated book depreciation of $16,000 corresponds to the excess of the tax gain over the book gain on the sale.
Financial accounting change in accumulated depreciation on the fixed asset sold
Beginning of the year $54,000
End of the year 0
Net change $54,000
Tax accounting change in accumulated depreciation on the fixed asset sold
Beginning of the year $70,000
End of the year 0
Net change $70,000
By what amount will PCC decrease its deferred tax liabilities as a result of the decrease in the tax-over- book basis in this asset from the beginning of the year to the end of the year?
Answer: $3,360, computed as $16,000 × 21 percent.
What tax accounting journal entry does PCC record related to this transaction?
Answer:
Deferred income tax liability 3,360
Deferred income tax benefit 3,360
This drawdown of the excess of tax accumulated depreciation over book accumulated deprecia- tion requires a reduction in the previously recorded deferred tax liability that resulted from the book–
tax difference created by the excess of tax depreciation over book depreciation in prior periods.
By what amount will PCC increase its current income tax expense as a result of this transaction (the tax gain was $70,000)?
Answer: $14,700, computed as $70,000 × 21 percent.
What tax accounting journal entry does PCC record related to this transaction?
Answer:
Current income tax expense 14,700
Income taxes payable 14,700
What is the net impact of this transaction on PCC’s income tax provision?
Answer: A net increase of $11,340, computed as:
Current income tax expense $ 14,700
Deferred income tax benefit (3,360)
Net increase in PCC’s income tax provision $11,340
What do these journal entries accomplish?
Answer: The $11,340 provision reflects the tax expense related to the book gain of $54,000, com- puted as follows:
Book gain on sale of the fixed asset $ 54,000
× 21%
Net increase in PCC’s income tax provision $11,340
The recording of a deferred tax liability for years in which tax depreciation exceeds book depreciation anticipates the difference in the book and tax gain that will result when the fixed asset eventually is recovered, either through sale or depreciation of the entire basis.
Using a template that tracks the cumulative changes in the book–tax differences re- lated to balance sheet accounts becomes especially important when a company’s enacted tax rate changes. For example, the Tax Cuts and Jobs Act reduced the corporate tax rate to 21 percent for tax years beginning after December 31, 2017. The bill was signed by the president on December 22, 2017. As a result, corporations were required to revalue their U.S. deferred tax assets and liabilities existing on December 22, 2017, to reflect the lower tax rate. This discussion points to the fact that the focus of ASC 740 is to have the balance sheet deferred tax accounts reflect the tax that will be due or refunded when the underlying temporary differences reverse in a future period.
Example 17-8
Using her cumulative temporary differences template, Elise recorded the cumulative taxable tempo- rary differences and the corresponding deferred tax liability at the beginning of the year (BOY) and the end of the year (EOY) to determine the change in the deferred tax liability related to accumulated depreciation.
Premiere Computer Corporation Temporary Difference Scheduling Template
BOY Beginning Current- EOY Ending Taxable Cumulative Deferred Year Cumulative Deferred Temporary Differences T/D Taxes (@ 21%) Change T/D Taxes (@ 21%)
Accumulated
depreciation (10,000,000)* (2,100,000) (684,000) (10,684,000) (2,243,640)
*$22,000,000 − $12,000,000, from Example 17-6.
What is the net increase in PCC’s deferred tax liability related to fixed assets for 2018?
Answer: $143,640, the change in the cumulative deferred tax liability from the beginning of the year ($2,100,000) to the end of the year ($2,243,640).
This amount corresponds to the increase in the deferred tax liability due to the current-year change in the book–tax difference related to depreciation ($700,000) less the reduction in the deferred tax liability due to the change in the book–tax difference related to accumulated depreciation written off on the sale of the fixed asset ($16,000).
What tax accounting journal entry does PCC record related to the change in total deferred tax liabili- ties from the beginning of the year to the end of the year?
Answer:
Deferred income tax expense 143,640
Deferred income tax liability 143,640
Example 17-9
What if: Assume PCC’s tax rate decreased from 34 percent in 2017 to 21 percent in 2018. By what amount would PCC increase or decrease its balance sheet deferred tax liability related to the fixed asset account?
(continued on page 17-16 )
Answer: PCC would decrease its deferred tax liability related to fixed assets by $1,300,000, calculated as follows:
Premiere Computer Corporation Temporary Difference Scheduling Template
Taxable Cumulative T/D as of Deferred Revalued Cumulative Temporary Differences December 22, 2017 Taxes (@ 34%) T/D (@21%)
Accumulated
depreciation (10,000,000) (3,400,000) (2,100,000)
PCC would use a tax rate of 21 percent to compute the ending balance in its deferred tax liability related to fixed assets as of December 22, 2017. The net decrease in the deferred tax liability related to accumulated depreciation is $1,300,000 ($3,400,000 − $2,100,000).
What tax accounting journal entry did PCC record on December 22, 2017, related to fixed assets?
Answer:
Deferred income tax liability 1,300,000
Deferred income tax expense 1,300,000
This “prior period adjustment” to the deferred tax liability balance would reduce PCC’s income tax provision in the fourth quarter of 2017 and be treated as a “discrete item” in the company’s effective tax rate reconciliation for 2017 (discussed later in the chapter).
Returning to her temporary differences template, Elise recorded the deductible (cumulatively unfavorable) temporary differences and the corresponding deferred tax assets at the beginning of the year (BOY) and the end of the year (EOY) to determine the change in PCC’s deferred tax assets during the current year.
Example 17-10
Premiere Computer Corporation Temporary Difference Scheduling Template
BOY Beginning Current- EOY Ending Deductible Cumulative Deferred Year Cumulative Deferred Temporary Differences T/D Taxes (@ 21%) Change T/D Taxes (@ 21%)
Allowance for bad debts $ 345,000 $ 72,450 $ 70,000 $ 415,000 $ 87,150 Reserve for warranties 430,000 90,300 170,000 600,000 126,000
Net operating loss 24,000 5,040 (24,000) 0 0
Deferred compensation $ 1,200,000 252,000 (150,000) 1,050,000 220,500
Stock option compensation 0 0 100,000 100,000 21,000
Net capital loss carryover 0 0 28,000 28,000 5,880
Contribution carryover 0 0 73,700 73,700 15,477
Total $1,999,000 $419,790 $ 267,700 $2,266,700 $476,007
What is the net increase in PCC’s total deferred income tax assets for 2018?
Answer: $56,217, the change in the cumulative deferred tax asset from the beginning of the year balance of $419,790 to the end of the year balance of $476,007.
What tax accounting journal entry does PCC record related to deferred tax assets?
Answer:
Deferred income tax assets 56,217
Deferred income tax benefit 56,217