Deferred Tax Liability and Asset

Recall that deferred tax assets and liabilities originate from temporary differences between financial accounting profit and taxable income.  Specifically, deferred tax assets indicate taxes that have already been paid or losses carried forward from prior periods but are not yet reflected on the income statement. On the other hand, deferred tax liabilities arise when the tax expense recorded for financial accounting exceeds the tax expense per tax regulations.

At the end of each reporting period, companies compare the tax bases and carrying amounts of balance sheet items to recalculate deferred tax assets and liabilities. These adjustments are combined with income tax payable to determine the company’s income tax expense (or credit) on the income statement.

When statutory tax rates change, the reported value of deferred tax assets and liabilities must be adjusted accordingly. For example, if the corporate tax rate is reduced from 35% to 30%, the value of deferred tax assets decreases because the future tax benefit is reduced. Similarly, the value of deferred tax liabilities decreases as the future tax obligation diminishes.

Treatment of Deferred Tax Liabilities and Assets for the Purposes of Financial Analysis

Assume that a company, depreciates its machinery on a straight-line basis at a rate of 8% per year. However, tax authorities allow for a depreciation rate of 12% per year. Consequently, at the end of the fiscal year, this creates a situation where the carrying amount of the machinery for accounting purposes is higher than its tax base, resulting in a temporary difference.

A deferred tax asset can be created if the company expects to realize the economic benefit of this asset in the future.In this scenario, since the machinery is essential to the company’s core business and the company is a going concern with stable earnings, it is reasonable to expect future economic benefits from the machinery. Therefore, creating a deferred tax asset would be appropriate.

Conversely, if there were doubts about the realization of future economic benefits from the temporary difference, for example, when the company is liquidated, the temporary difference would not result in the recognition of a deferred tax asset.

It is important to note that if a deferred tax asset had been recognized previously but doubts arose about the realization of economic benefits, then under IFRS, the deferred tax asset would be reversed. However, under US GAAP, a valuation allowance would be set up to reduce the deferred tax asset to the amount that is more likely than not to be realized.

It is crucial to note that management discretion plays a significant role in assessing temporary differences and the likelihood of future economic benefits.

Example: Treatment of Deferred Tax Liabilities and Assets for the Purposes of Financial Analysis

A hypothetical company, Galaxy Manufacturing, reports under IFRS. A snippet of the company’s consolidated income statement is given below:

$$\begin{array}{l|c|c|c}
\textbf{Period Ending 31 December} & \textbf{Year 3} & \textbf{Year 2} & \textbf{Year 1} \\
\hline
\text{Revenue} & \$50,000 & \$40,000 & \$30,000 \\\hline
\text{Other net gains} & 3,000 & 0 & 0 \\\hline
\text{Changes in inventories}  & 600 & 300 & 400 \\\hline
\text{Raw materials Costs} & (6,500) & (5,000) & (9,000) \\\hline
\text{Depreciation expense} & (2,500) & (2,500) & (2,500) \\\hline
\text{Other expenses} & (7,000) & (6,800) & (5,500) \\\hline
\text{Interest expense} & (2,500) & (3,500) & (7,000) \\\hline
\textbf{Profit before tax} & \textbf{\$35,100} & \textbf{\$22,500} & \textbf{\$6,400} \\
\end{array}$$

In the above income statement, assume that all income and expenses on the income statement are treated identically for tax and accounting purposes except for depreciation related to equipment owned by Galaxy Manufacturing.  Moreover, assume the equipment was purchased at the beginning of Year 1 for $25,000. As such, depreciation should thus be calculated and expensed for the full year.

Accounting standards (IFRS in this case) permit equipment to be depreciated on a straight-line basis over a 10-year period, while tax standards specify depreciation over a 7-year period. Assume a salvage value of $0 at the end of the equipment’s useful life. Assume a tax rate of 30%.

From the above information,

1. Calculate the taxable income of the company
2. Calculate the carrying amount and tax base for the equipment
3. Determine whether the difference in the depreciation method in determining accounting profit and taxable income results in deferred tax liability or asset. Also, the value for each year will be determined.
4. Determine income tax expense for each year.

Solution

Taxable income:

The equipment was initially acquired for $25,000. According to accounting standards, the company will recognize annual depreciation of $2,500 (=\(\frac{$25,000}{10}\)) over the next 10 years, which will be recorded as an expense on the income statement and used to calculate accounting profit (as demonstrated in the data above).

For tax purposes, however, the company will recognize $3,571 (\(\approx\frac{$25,000}{7}\)) in yearly depreciation. Consequently, the depreciation expense will differ each fiscal year for tax and accounting purposes (tax base vs. carrying amount), leading to a difference between accounting profit and taxable income. The taxable income for each fiscal year is outlined below:

$$\begin{array}{l|c|c|c}
\textbf{Period Ending 31 December} & \textbf{Year 3} & \textbf{Year 2} & \textbf{Year 1} \\
\hline
\text{Revenue} & \$50,000 & \$40,000 & \$30,000 \\\hline
\text{Other net gains} & 3,000 & 0 & 0 \\\hline
\text{Changes in inventories}  & 600 & 300 & 400 \\\hline
\text{Raw materials Costs} & (6,500) & (5,000) & (9,000) \\\hline
\text{Depreciation expense} & (3,571) & (3,571) & (3,571) \\\hline
\text{Other expenses} & (7,000) & (6,800) & (5,500) \\\hline
\text{Interest expense} & (2,500) & (3,500) & (7,000) \\\hline
\textbf{Taxable income} & \textbf{\$34,029} & \textbf{\$21,429} & \textbf{\$5,329} \\
\end{array}$$

Carrying amount and tax base for the equipment:

At the end of each balance sheet date, it is necessary to determine the tax base and carrying amount of all assets and liabilities, as shown below:

$$\begin{array}{l|c|c|c}
\textbf{Year} & \textbf{Year 3} & \textbf{Year 2} & \textbf{Year 1} \\
\hline
\text{Equipment value for accounting}&&&  \\\text{purposes (carrying amount)}&&&  \\\text{with Dep. of \$2,500 per year} & \$17,500 & \$20,000 & \$22,500\\ \hline
\text{Equipment value for}&&&\\\text{tax purposes (tax base)} &&&  \\\text{with Dep. of \$3,571 per year}& \$14,286 & \$17,857 & \$21,429 \\\hline
\textbf{Difference} & \textbf{\$3,214} & \textbf{\$2,143} & \textbf{\$1,071} \\
\end{array}$$

Value of Deferred Tax asset or Liability:

Remember that if the tax obligation is calculated based on accounting profits, it will differ due to the differences between the tax base and the carrying amount of the equipment. The table above highlights this difference.

In each fiscal year, the carrying amount of the equipment exceeds its tax base. Consequently, the asset’s tax base is lower than its carrying value according to financial accounting principles for tax purposes. This difference results in a deferred tax liability, as shown in the following table:

$$\begin{array}{l|c|c|c}\textbf{Year} & \textbf{Year 3} & \textbf{Year 2} & \textbf{Year 1} \\\hline
\text{Deferred tax liability} & \$964 & \$643 & \$321 \\
\end{array}$$

Note that the above values are calculated as:

$$\text{Deferred tax liability}=\text{(Tax base – Carrying amount)} \times \text{tax rate}$$

So that,

Year 1: \((\$22,500 – \$21,429) \times 30\ \text{percent} = \$321\)
Year 2: \((\$20,000 – \$17,857) \times 30 \ \text{percent} = \$643\)
Year 3: \((\$17,500 – \$14,286) \times 30 \ \text{percent} = \$964\)

Income tax expense for each year:

Intuitively, the different treatment of depreciation creates a temporary difference, leading to the income tax on the income statement being 30 percent of the accounting profit. However, only a portion of this is income tax payable, with the remainder being a deferred tax liability. Therefore, on the income statement, the company’s income tax expense will be the sum of the change in the deferred tax liability and the income tax payable, as shown below:

$$\begin{array}{l|c|c|c}
\textbf{Year} & \textbf{Year 3} & \textbf{Year 2} & \textbf{Year 1} \\
\hline \text{Income tax payable}&&&\\\text{(based on tax accounting)} & \$10,209 & \$6,429 & \$1,599 \\\hline \text{Change in}&&&\\\text{deferred tax liability} & \$321 & \$322 & \$321 \\ \hline
\textbf{Income tax expense}&&&\\\textbf{(based on financial accounting)} & \textbf{\$10,530} & \textbf{\$6,751} & \textbf{\$1,920} \\
\end{array}$$

Note that if there was a presence of both deferred tax liabilities and assets, income tax expense would be calculated as:

$$\begin{align}\text{Income tax expense}\ = &\text{Taxes payable}\ \textbf{plus}\\&\text{net increase in deferred tax liabilities}\\&\textbf{less}\\ &\text{net increase in deferred tax assets}\end{align}$$

Given all the information above, we can now present the consolidated income statement of Galaxy Manufacturing, reflecting the income tax as shown below:

$$\begin{array}{l|c|c|c}
\textbf{Period Ending 31 December} & \textbf{Year 3} & \textbf{Year 2} & \textbf{Year 1} \\
\hline
\text{Revenue} & \$50,000 & \$40,000 & \$30,000 \\\hline
\text{Other net gains} & 3,000 & 0 & 0 \\\hline
\text{Changes in inventories of}&&&\\\text{finished goods and work in progress} & 600 & 300 & 400 \\\hline
\text{Raw materials}&&&\\\text{and consumables used} & (6,500) & (5,000) & (9,000) \\\hline
\text{Depreciation expense} & (2,500) & (2,500) & (2,500) \\\hline
\text{Other expenses} & (7,000) & (6,800) & (5,500) \\\hline\text{Interest expense} & (2,500) & (3,500) & (7,000) \\\hline
\textbf{Profit before tax} & \textbf{\$35,100} & \textbf{\$22,500} & \textbf{\$6,400} \\\hline
\text{Income tax} & (10,530) & (6,751) & (1,920) \\\hline
\textbf{Profit after tax} & \textbf{\$24,570} & \textbf{\$15,749} & \textbf{\$4,480} \\
\end{array}$$

Question

Which of the following statements is the least accurate?

1. Deferred tax assets and liabilities are recalculated at the end of each financial year.
2. Deferred tax assets and liabilities are based on permanent differences, which result in a company paying an excess or deficit amount for taxes.
3. A deferred tax asset or liability will not be created if there is no guarantee that future economic benefits will be derived from a temporary difference.

Solution

The correct answer is B.

Deferred tax assets and liabilities are based on temporary, not permanent, differences that result in a company paying an excess or deficit amount for taxes.

Options A and C are correct statements.