From my FAR lesson on deferred taxes.
Short answer: ask one question about each temporary difference: will it make me pay more tax later, or less tax later? More tax later is a deferred tax liability. Less tax later is a deferred tax asset. Measure it at the enacted tax rate for the years it reverses.
Temporary vs permanent differences
Book income (GAAP) and taxable income (the tax return) differ for two kinds of reasons:
- Temporary differences reverse over time. The total is the same, only the timing differs. These create deferred taxes.
- Permanent differences never reverse, such as municipal bond interest (never taxed) or fines and penalties (never deductible). No deferred tax at all.
Worked example
In Year 1 a company has pretax book income of $100,000 and a 21% enacted tax rate for all years. Two temporary differences:
- Depreciation: $20,000 for books, $50,000 for tax (accelerated). The company deducts $30,000 more on this year’s return, so it will deduct less later and pay more tax later. That is a deferred tax liability: $30,000 x 21% = $6,300.
- Warranty expense: $12,000 accrued for books, but deductible for tax only when paid, and none was paid in Year 1. The deduction is coming later, so the company will pay less tax later. That is a deferred tax asset: $12,000 x 21% = $2,520.
Taxable income: $100,000 – $30,000 + $12,000 = $82,000. Current tax payable: $82,000 x 21% = $17,220.
Total income tax expense: current $17,220 + deferred ($6,300 – $2,520 = $3,780) = $21,000, which is 21% of book income, as expected with a single flat rate and no permanent differences.
The journal entry
| Account | Debit | Credit |
|---|---|---|
| Income tax expense | 21,000 | |
| Deferred tax asset | 2,520 | |
| Income taxes payable | 17,220 | |
| Deferred tax liability | 6,300 |
Common traps on the exam
- Using the current rate when a different future rate is enacted. Deferred taxes use the enacted rate for the years the difference reverses.
- Booking deferred tax on a permanent difference. Municipal bond interest and fines never create a DTA or DTL.
- Ignoring the valuation allowance. If it is more likely than not (over 50%) that some of a deferred tax asset will not be realized, reduce it with a valuation allowance.
- Current vs noncurrent. Under US GAAP, deferred tax assets and liabilities are all classified as noncurrent on the balance sheet. Within one tax jurisdiction they are netted, so this company shows a single net noncurrent deferred tax liability of $3,780.
FAQ
Is accelerated tax depreciation a DTA or DTL? A DTL. You deduct more now and less later, so you pay more tax later.
Is a warranty accrual a DTA or DTL? A DTA. The book expense comes first and the tax deduction comes later, so you pay less tax later.
Where does the deferred amount show up on the income statement? It is part of income tax expense, alongside the current portion.
Studying for FAR? I teach these topics as Lead Instructor at Copernicus CPA Review, where you can watch the full lessons.
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