Questions for Review of Key Topics
Income tax expense is comprised of both the current and the deferred tax consequences of events and transactions already recognized. Specifically, it includes (a) the income tax that is payable currently and (b) the change in the deferred tax liability (or asset). Apparently, in the situation described, temporary differences required a $4.4 million increase in the deferred tax liability, a $4.4 million decrease in the deferred tax asset, or some combination of the two.
Temporary differences between the reported amount of an asset or liability in the financial statements and its tax basis are primarily caused by revenues, expenses, gains, and losses being included in taxable income in a year earlier or later than the year in which they are recognized for financial reporting purpose, although there are other, less common, events that can cause these temporary differences. Some temporary differences create deferred tax liabilities because they result in taxable amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse). An example is the receivable created when installment sale gross profit is recognized for financial reporting purposes. When this asset is recovered, taxable amounts are produced because the installment sale gross profit is then recognized for tax purposes. Some temporary differences create deferred tax assets because they result in deductible amounts in some future year(s) when the related assets are recovered or the related liabilities are settled (when the temporary differences reverse). An example is the liability created when estimated warranty expense is recognized for financial reporting purposes. When this liability is settled, deductible amounts are produced because the warranty cost is then deducted for tax purposes. The deferred tax liability or asset each year is the tax rate times the temporary difference between the financial statement carrying amount of the receivable or liability and its tax basis.
Future deductible amounts mean that taxable income will be decreased relative to pretax accounting income in one or more future years. Two examples are (a) estimated expenses that are recognized on income statements when incurred, but deducted on tax returns in later years when actually paid and (b) revenues that are taxed when collected, but are recognized on income statements in later years when actually earned. These situations have favorable tax consequences that are recognized as deferred tax assets.
Deferred tax assets are recognized for all deductible temporary differences and operating loss carryforwards. However, a deferred tax asset is then reduced by a valuation allowance if it is “more likely than not” that some portion or the entire deferred tax asset will not be realized. The decision as to whether a valuation allowance is needed should be based on the weight of all available evidence. Answers to Questions (continued)
Nontemporary or “permanent” differences are caused by transactions and events that under existing tax law will never affect taxable income or taxes payable. Some provisions of the tax laws exempt certain revenues from taxation and prohibit the deduction of certain expenses. Provisions of the tax laws, in some other instances, dictate that the amount of a revenue that is taxable or expense that is deductible permanently differs from the amount reported in the income statement. Permanent differences are disregarded when determining both the tax payable currently and the deferred tax effect.
Examples of nontemporary or “permanent” differences are: •Interest received from investments in bonds issued by state and municipal governments (not taxable) •...