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Deferred Income Taxes.docx

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Kristie Dewald

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Deferred income taxes (also referred to as “future income taxes”) We have seen before that income calculated for accounting purposes is governed by “GAAP” whereas income calculated for tax purposes is governed by tax law. At times, the 2 sets of rules differ. These differences result in a measure of income for tax purposes that is different from income for accounting (net income). These differences create “deferred income taxes”. There are a number of items that are treated differently for tax than they are for accounting. When we were looking at property, plant and equipment, we discussed that depreciation policies should be determined to best reflect how the asset is used. Tax law, on the other hand has a different set of objectives and provides depreciation methods and rates for Capital Cost Allowance, which is depreciation for tax purposes. Often depreciation for accounting is different from CCA for tax. This creates a difference between net income for tax and net income for accounting, but it also gives us different ending Net Book Values. Another area that commonly has differences is warranty liabilities. Accounting rules would have us estimate the cost of future warranties at the time we record the revenue in order to match the cost to the revenue. When we make that estimate, we would prepare the following journal entry: Dr. Warranty expense XX Cr. Warranty liability XX For taxes, companies are not permitted to use this expense; they are only allowed to deduct actual warranty expenses paid for in the year. Again, there would be a mis- match as to when the expense is deducted for accounting than for tax. The question is “what do we do with these differences”? Ignore them? Account for them in some way? The answer accounting standards setters have come up with is that we account for them. The method we use is called the “tax allocation” method. This method recognizes that there are tax consequences to economic events that need to be recognized regardless of whether the tax impact occurs in the current year or in future years. Let’s look at an example for property, plant and equipment. Assume that on January 1, 2010, Logistics Ltd. purchases a truck for $100,000. The company chooses to depreciate the truck on a straight line basis over 10 years. Tax law provides that vehicles are depreciated on a declining balance bases at a rate of 30%. The following table compares the expense for each year as well as the ending net book value for each year. Accounting Tax Expens e NBV CCA* UCC*** 100,00 100,00 Cost 0 0 10,00 90,00 15,00 85,00 2010 0 0 0** 0 10,00 80,00 25,50 59,50 2011 0 0 0 0 10,00 70,00 17,85 41,65 2012 0 0 0 0 10,00 60,00 12,4 29,15 2013 0 0 95 5 10,00 50,00 8,74 20,4 2014 0 0 7 08 10,00 40,00 6,12 14,2 2015 0 0 2 86 10,00 30,00 4,28 10,0 2016 0 0 6 00 10,00 20,00 3,00 7,00 2017 0 0 0 0 10,00 10,00 2, 4,90 2018 0 0 100 0 10,00 1, 2019 0 - 470 3,430 * For tax, depreciation is called “capital cost allowance” or CCA. It is always calculated using the declining balance method ** tax rules require that companies deduct ½ of the CCA in the year of acquisition. *** for tax, the term Undepreciated Capital Cost is used instead of net book value. Let’s look at the net book value at the end of 2010. For accounting, NBV = 90,000, which tells us that there will be $90,000 deducted from net income in the future through future depreciation expense. For taxes, the ending value of UCC is $85,000. This is the amount that is available to reduce tax income through future CCA claims/deductions. If all other things were equal, tax income in all years in the future will be higher than accounting income for the same years because there is less to deduct for depreciation/CCA. As a reader of financial statements, we are not privy to the tax information – all we can see is the accounting net book value. If I know that companies like Logistics generally have a tax rate of 30%, I might draw the conclusion that the company will be able to deduct $90,000 of depreciation on its future tax returns and thereby reducing the tax amounts owing by $90,000 x 30% = $27,000. If I could see the tax information, I would know that is not the case. Rather than publishing the tax information for the statement readers, we account for this difference in another way – with deferred income taxes. Specifically in this case, the difference would create something called a “deferred income tax liability”. This tells the readers that the company will owe more tax than might otherwise be expected, due to differences in accounting and tax rules. At the end of the day, the company will be deducting the full amount of the asset for both accounting and tax. What differs is the timing of those deductions. In this case, there would be a deferred income tax liability of: (NBV for accounting) 90,000 – (UCC for tax) 85,000 = 5,000 x (tax rate) 30% = $1,500 This reflects that the company will not, in fact, save $27,000 in tax as calculated in the previous paragraph. Because there is a future liability of $1,500, the benefit of future deductions will only be $25,500 (27,000 less 1,500). Since we have the tax information in this case, we know this is true, as the company will deduct $85,000 and at a tax rate of 30%, the savings will be $25,500. Now let’s assume that Logistics’ net income for 2010 was $200,000, after considering depreciation. The taxable income would be: Income for accounting $ 200,000 Add back depreciation 10,000 not permitted as a deduction for tax Deduct CCA (15,000) permitted as a deduction for tax Taxable income 195,000 Taxes that are owing to the government are based on taxable income, not accounting net income. As such, Logistics would be required to send a cheque to the government for $195,000 x 30% = $58,500. We record this as “current tax expense”. Dr. Current income tax expense 58,500 Cr. Current income tax payable 58,500 (or cash if paid immediately) We also need to set up the deferred income taxes. Assuming we started with no balance at the beginning, we need to set up a deferred tax liability of $9,0
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