yancey Wrote:
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> deferred tax assets and liabilities, taxable
> income, pre tax income, permanent differences vs.
> temporary differences, liability method, valuation
> allowance.
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Okay, so I'll try to give a plain english explanation for these items (simplified, so there are exceptions to some things I say. I want to make sure everyone understands the basics here, and will answer esothric issues later)
First, you start with a company's income statement. When you pull out the tax form and start transferring numbers over onto that form its not an exact transfer. Some items/amounts will differ between the two and that's the main reason we have deferred taxes. And since what appears on the income statement this year (for example) may not show up until years later on the tax return, this is why deferred tax accounts can be long term in nature.
Tax expense is the expense (debit) on your income statement for the current year. Taxes Payable is the short-term liability based on what you owe from the bottom of the tax form (assume no estimates paid during the year). The difference affects the deferred accounts.
If you owe more than you showed on your income statement, you are in affect prepaying taxes and have a deferred tax asset. If you owe less now than you showed on your income statement, then you have a future obligation to pay taxes and record a deferred tax liability. Each of these arose from a specific item which is treated differently for tax and GAAP recognition purposes (and I also assumed that only one haappened at a time). An example of something which will give rise to a deferred tax asset is warrenty expense. A company that sells something with a multiyear warrenty can take a GAAP deduction in the current year for what they expect to incur in the future under the terms of the warrenty, but for tax pirposes this can't be deducted until that future year when it haappens. Deferred tax liabilities most commonly arise from using a tax depreciation method that records higher taxes in early years on your return than on your income statement.
You can have multiple items which originated in multiple years and effect different future years, which is why you can have several categories of tax assets and liabilities on your balance sheet.
Taxable income as the amount per your TAX RETURN that you take to the tax tables to figure out how much you owe the IRS.
Pretax income is the subtotaled amount on your INCOME STATEMENT before the claculation of tax expense.
A permanent difference is an item of expense/income on your income statement that you will NEVER have to pay taxes on. An example is interest income on investments in certain types of municipla bonds. So if you have $1000 of pre-tax income and it includes $50 of tax free interest, you would subtract that amount out to get $950 before applying the tax rate to calculate taxe expense for the income statement
A temporary difference is an item of expense that will appear on both the tax return and income statement, but in different periods. For example, you might have a $600 asset that you depreciate in 3 equal amounts of $200 for income statement ("book") purposes, but take as $300, $200, $100 in 3 consecutive years for tax purposes. This creates a deferred tax liability in year one when book depreciation is lower by $100, and the libility is wiped out ("reversed") in year 3 when the book amount is higher by that same amount.
Liability method. Let's say that this year I record $1000 of income when the current (and expected future) tax rate is 40%, but I don't have to pay taxes on it until year 5. I record a $400 (40% * $1000) liability. Suppose in year 3 tax rates are dropped to 35%. I now know that in two years when i put this $1000 on my tax return I will only end paying $350 and not the $400 liability that i originally established. I then reduce my liability by $50 along with the current (year I find out about the change) income tax expense. The objective is always to make sure that the liabilities and assets are correct and to catch up for any changes or differences in the tax laws by an adjustment to the curretn periods income tax expense.
The valuation allowance for deferred tax assets is exactly the same in concept as the allowance for doubtfull accounts that you subtract from your accounts receivable. You have a face amount of caclulated asset, but you're unsure if you will ever realize the benefit of that asset in the future, so you knock down the amount via the allowance to what you think is the likely amount to be realized, with the offset to income tax expense on the income statement. If they ask a problem on this it would have to be very clearly stated (practically given to you).
Helpfull, or a waste of my time?