A few weeks ago, you were introduced to the overall income tax provision in this blog post. In that post, we recalled the basic formula determining the income tax provision:

Current tax expense/benefit + Deferred tax expense/benefit = Total income tax expense or benefit as reported in the financial statements.

We’ve reviewed the formula for current tax expense or benefit already. In this post, we’ll focus on the 2^nd part of that equation, deferred tax expense or benefit, including the determination of whether or not an entity must record a valuation allowance.

Deferred Taxes

Where do deferred taxes arise? Well, tax rules have different recognition criteria for assets and liabilities in comparison to U.S. GAAP. A temporary difference arises when there is a difference between the tax basis of an asset or liability and its reported amount in the financial statements.

For instance, let’s say a company has a piece of equipment on its books that is classified as property, plant, and equipment (PP&E). We know that this asset will be recognized on both the U.S. GAAP books and the tax books because the company made the purchase and paid cash. So why is there a difference? Depreciation! Depreciation methods used for tax purposes are often more accelerated than the methods used for financial purposes, resulting in deductions taken on the tax return before the expense is included in the financial records. Therefore, the accumulated depreciation is generally higher for tax purposes than it is for financial purposes. This results in a temporary difference that will ultimately reverse once the asset is completely depreciated for both book and tax purposes.

Until this difference reverses, it will give rise to either a future taxable amount or a future deductible amount. In our example, it will give rise to a future taxable amount, which means the company would need to recognize a deferred tax liability. More on that later…

A Five-step Approach

In our course, Income Taxes: Deferred Taxes and Valuation Allowance, we introduce you to a five-step approach for identifying, measuring, and recognizing deferred taxes and the associated valuation allowance, if needed. This approach is based off of the guidance found in ASC Topic 740. Let’s take a look at each of those five steps now.

Step 1: Identify Temporary Differences

Step 1 is to identify temporary differences by determining basis differences between the U.S. GAAP and tax balance sheets that will result in future tax consequences. We performed this step earlier when we identified a temporary difference between the tax basis of PP&E and our U.S. GAAP basis of PP&E due to the different rates of depreciation being applied under either model.

Other common temporary differences include (but most definitely are NOT limited to):

• Allowance for doubtful accounts
• Estimated customer sales rebates
• Accrual for returns
• Inventory – reserves
• Buildings & improvements – accumulated depreciation
• Machinery & equipment – accumulated depreciation
• Accruals – warranty, vacation, and bonus

 Step 2: Categorize temporary differences

Step 2 is to categorize the temporary differences into future taxable and future deductible amounts. If a temporary difference is taxable, it results in a deferred tax liability once the appropriate tax rate is applied. If a temporary difference is deductible, it results in a deferred tax asset once the appropriate tax rate is applied. So, the question is: How do you tell if it is a future deductible or future taxable amount? In other words, are you recording a deferred tax asset or a deferred tax liability? Well, lucky for you, I have a fool-proof way to figure it out! 

1. Look at your U.S. GAAP balance sheet number. Is it an asset or liability?
2. Compare that number to its tax basis. Is the U.S. GAAP number higher or lower?

You can then use the chart below to determine whether or not you have a future taxable amount (deferred tax liability) or future deductible amount (deferred tax asset):

In our earlier example, the PP&E account (an asset) was likely higher on our U.S. GAAP books because of accelerated depreciation being taken for tax purposes. Therefore, this temporary difference will result in a future taxable amount, or a deferred tax liability.

Step 3: Determine the appropriate tax rate

In order to record that deferred tax liability, we need to apply step three to determine the appropriate tax rate to use in the calculation of deferred taxes.

The appropriate tax rate is the enacted tax rate applicable when the temporary differences are expected to reverse. Anticipated tax rates should never be used because they are not yet enacted into law! Sounds easy enough right? Well, it can get a bit more complex if there are graduated tax rates or different tax rates for different types of income. Need to know more? You’ll have to take our course to find out!

Step 4: Calculate and record deferred tax assets and liabilities

The next step is the actual calculation of deferred taxes! The appropriate tax rate to use is that which was determined in Step 3.

Normally deferred tax liabilities and deferred tax assets are recorded with the offsetting entry to deferred tax expense (benefit) in the income statement. However, as you’ll learn in the course, that is not always the case.

Step 5: Consider the need for a valuation allowance

We have (finally) arrived at step 5, which is to consider the need for a valuation allowance if it is more likely than not that a deferred tax asset will not be realized. Under U.S. GAAP, deferred tax assets are recorded in full. Next, the recoverability of the deferred tax assets is assessed, and a valuation allowance is recorded if necessary.

Valuation allowances are needed if it is more likely than not (>50%), based on all available evidence, that some or all of the deferred tax assets will not be realized. The “more likely than not” criterion for determining whether a valuation allowance is needed for deferred tax assets relates to the ability of the company to utilize the related tax deductions, not whether or not a particular tax position will be sustained by the taxing authority. Said another way, will they have enough income in future periods to actually utilize their deferred tax assets? In fact, there are four sources of income you should consider when assessing whether or not a valuation allowance is needed.

A valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more-likely-than-not to be realized. It is not an “all or nothing” decision and is not a one-time consideration! Partial valuation allowances can be made. As you can imagine, this determination involves significant judgment, and, as a result, a significant amount of time is spent on this topic in the course.

Did this post leave you thirsty for more knowledge on the accounting for income taxes under ASC Topic 740? I hope so! Check out this post for an example of accounting for uncertain tax positions under ASC 740.

Also, be sure to check out our collection of online eLearning courses related to the accounting for income taxes under U.S. GAAP.

Disclaimer  

This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.