In part I of the income tax footnote discussion, we covered the fundamental reasons why deferred taxes even exist. In part II of the series, I will try my best to explain the concept of deferred tax assets and deferred tax liabilities.
In the most simple terms, deferred tax assets potential reductions in future taxes payable whereas deferred tax liabilities are potential increase in future taxes payable. Roughly but suffice to remember DTA can reduce future tax liabilities and DTA can increase future tax liabilities.
Whether a temporary difference will result in DTA or DTP depends on only one key question – will the tax book income > the financial book income in the future when the difference in timing is resolved (or when the situation reversed)? If the answer is yes, then it will be DTP. If the answer is no, then it will be DTA.
Let’s take a look at 2 simple examples. Remember to focus on the key question.
Example 1: Let’s say you own an apartment complex, and you charge $10,000 a year. Your tenant has just signed a two-year contract and paid $20,000 upfront. Assume a 30% tax rate.
In year 1, on your tax book, you will recognize $20,000 of taxable income and have a $6,000 taxes payable to IRS.
However, on your financial book, you only get to recognize $10,000 during year 1 because of the accrual method. Therefore, on your financial book, you only have a $3,000 tax liability.
Now year 2 comes and the situation reverses. You recognize 0 income on your tax book but still $10,000 on your financial book. Your tax book has 0 tax liability whereas your financial book still shows a $3,000 tax liability.
It is December 31 of year 1, you want to determine whether you should record a DTA or DTP on your financial statement. Therefore, you ask this question – is the tax book income > financial book income in year 2? From our analysis above, it is obvious that the answer is no. So you will record a DTA on your balance sheet.
Example 2: You bought a car for your business for $15,000 and again assume a 30% tax rate and a 5-year useful life and $0 salvage value. Your only other income is $10,000 a year.
Under financial accounting, the most frequently used depreciation method is straight line so we will use the straight-line method, which means our depreciation expense is $3,000 a year in the next 5 years.
Under the tax regulation, you can choose to use the accelerated depreciation method. For simplicity purposes, let’s assume during the next 5 years, you can depreciate the car at the following rate:
Year 1: $5,000
Year 2: $4,000
Year 3: $3,000
Year 4: $2,000
Year 5: $1,000
To make things as clear as possible, I’ve made the following table to illustrate the steps used to determine whether you should record a DTP or DTA. I’ve personally found this exercise very useful.
| Year | Tax Depr | Financial Depr | Tax Book Income | Financial Book Income | Difference Origination or Reverse? | Is future tax book income> future financial book income when difference reverses? | DTA or DTP |
| 1 | 5,000 | 3,000 | 5,000 | 7,000 | Origination | Yes | DTP |
| 2 | 4,000 | 3,000 | 6,000 | 7,000 | Origination | Yes | DTP |
| 3 | 3,000 | 3,000 | 7,000 | 7,000 | No difference | N/A | N/A |
| 4 | 2,000 | 3,000 | 8,000 | 7,000 | Reverse | N/A | N/A |
| 5 | 1,000 | 3,000 | 9,000 | 7,000 | Reverse | N/A | N/A |
Two things to note from the above table:
1. You only record DTP or DTA at the time of the origination of temporary differences.
2. Remember the key question. Yes -> DTP No-> DTA.
I apologize for the lengthy examples but I hope the readers can have a better understanding of DTA and DTP by now.
It is getting to the point where added explanation may deteriorate comprehension. Therefore, I will stop here.
