Case Analysis

Topics: Balance sheet, Generally Accepted Accounting Principles, Depreciation Pages: 8 (2131 words) Published: May 6, 2013

1) What is the economic intuition and what are the concepts underlying deferred tax accounting? What goals/objectives are standard setters trying to achieve by requiring deferred tax accounting, compared to say, just having companies recognize tax expense as the cash paid (or at least currently owed) to the government?

The economic intuition of deferred tax accounting is to account for the differences between the tax expense shown in the financial statements and the current taxes payable to the government. Under the accrual method, management has a large amount of judgment as to when to recognize revenues and expenses. However, for tax purposes, cash is taxed when it is received. The difference in the time between when these revenues and expenses get recognized and when the cash is received gives rise to a temporary timing difference. Deferred tax accounting is necessary in order to better understand the true underlying economic value of the assets.

In the Apple example under subscription method, cash is collected today, but Apple could only recognize 1/8 of revenues and expenses. Therefore, taxes payable are higher than the tax expense under the accrual method. This gives rise to a deferred tax asset.

2) Use the information in case exhibits 3 and 4 to clearly explain how deferred tax assets and liabilities are created.

A deferred tax liability (DTL) is created when taxable income (financials) is greater than taxable income (tax return). In Exhibit 3, accounting income in year 1 equals $240 and the taxable income equals $100. By multiplying these numbers by the tax rate (40%) $96 is expensed, but only $40 is paid to the IRS. This means that $56 is owed in the financial statements, but the cash has not been received so the IRS has not collected. By subtracting the cumulative tax deductions from the cumulative deprecation ($140) and multiplying by the tax rate (40%) would equal at the current amount of the DTL.

In year 2, subtract the cumulative tax deductions to date from the accumulated depreciation ($266.67-$120=$146.67) and multiple by the current tax rate (40%) which equals a deferred tax liability of $58.67. If the income tax expense was less than the income tax payable, this would reduce the deferred tax liability (or create a deferred tax asset).

When the DTL reverses in year 3 (decreases), this signals that the income tax payable is greater than the income tax expense, or that the company is paying more tax in cash than expensing in the income statement ($240 taxable accounting < $267 taxable income). After multiplying by the tax rate ($96-106.67= -10.67), deferred tax liability decreases by $10.67. In years 4 and 5, the DTL decreases by $24 which removes the deferred tax liability because the timing differences have been accounted for in both the tax books and the financial statements.

It is essential to assume that the tax rate remains constant. An increase in the tax rate would decrease the tax liabilities faster, whereas as decrease in the overall tax rate would increase the value of deferred tax assets.

3) In the context of deferred tax accounting, what does it mean when we say we use the “balance sheet method?”

This question is answered based on the explanation in the case. The tax expense shown in the public financial statements is computed in accordance with the accounting choices. These choices often differ from those required for calculating current tax amounts payable to the government. Thus the tax expense and the tax payable may be significantly different in a given year.

In the context of deferred tax accounting, the balance sheet method is an approach that keeps track of the differences between tax and book accounting using accumulated accounts of balance sheet items. The cumulative value of each item with timing differences at the end of the year is calculated on a financial basis and a tax basis. The...
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