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Fundamentals of Tax Accruals |
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Example 2 – Deferred Tax Asset
Assume the same facts as Example 1, but at the end of year 2, Bizzer Corporation has pre-tax book income of $8,000. There are no permanent differences, but the company included in its financial statement income a deduction for Warranty Expenses of $2,000 that is expected to turn around in Year 4. Assume the enacted tax rate for years 1 through 4 is still 30% and in year 5 it still jumps to 40%. Calculate the tax provision for Bizzer Corporation for year 2.
Solution:
Under the liability method, the tax provision for the corporation is the sum of the federal taxes due for the year; plus or minus the net change in deferred taxes.
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Step 1: Calculate the Current Tax Liability |
| Pretax Book Income |
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$8,000 |
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| +/- Permanent Differences |
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-0- |
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| +/- Timing Differences |
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2,000
300
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(Non-deductible Warranty—until paid)
(gain reversal of installment sale) |
| Taxable Income |
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$10,300
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Tax Due (30% of $10,300) |
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$3,090 |
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Step 2: Calculate the Deferred Tax Liability |
Spreading the temporary differences to each of their reversing years completes this task.
Note that the spread now begins with Year 3.
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Year 3 |
Year 4 |
Year 5 |
Year 6 |
| Installment Receivable |
$ 300
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300
<2,000>
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300
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300
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| Total Entries by Year |
$ 300
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<1,700>
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300
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300
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| Tax Rate by Year |
30% |
30% |
40% |
40% |
| Annual Deferred Tax Liability |
$ 90
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<510>
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120
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120
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Therefore, under the measurement rules, the balance of the deferred tax liability or <Asset> at the end of Year 2 is the sum of the reversing temporary differences or <$180> ($90 – 510 + 120 + 120). Because the balance in the deferred tax account at the end of year one was $510, a net adjustment must be computed to reflect the <$180> balance that is required to exist at the end of Year 2. Accordingly, the deferred tax liability for Year 2 is:
$510 – <$180> = $690
(Note the double negative)
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Step 3: Calculate the Provision |
Adding together the current and deferred liabilities.
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Financial
Tax Provision |
= |
Current
Tax Liability |
– |
Deferred
Taxes Asset |
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? |
= |
$3,090 |
– |
690 |
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Accordingly, the tax provision for Bizzer Corporation is $2,400 ($3,090 – 690).
The journal entry to record this transaction would look like this:
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Because the debit to deferred taxes of $690 overpowers the ending credit balance in deferred taxes of $510, the ending balance becomes a deferred tax asset (a prepaid tax) on the books of the corporation. |
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Also note that the deferred tax asset of $690 equals the total temporary differences of $2300 @ 30% for the year. |
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It is important to understand that when a company has a deferred tax asset on the books, the balance must be scrutinized by the company. While it is not improper to have a deferred asset on the books, the very nature of the balance suggests that a "prepayment to the IRS" exists. The only manner in which a company can cash in that prepayment is to be assured that the company will have income in the future. Accordingly, when the company does not have this assurance, special valuation adjustments may have to be made to the deferred tax asset. |
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Copyright © 1998 Bizzer Professional Training |
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