Accounting in a Nutshell 4
Deferred Taxes
Joel Shapiro has been an
Accounting instructor at Ryerson
University in Toronto, Canada for
20 years. Previously, he developed
an accounting and inventory
management software system for
small businesses. In his spare time,
he enjoys working on Kakuro and
cryptic crossword puzzles, and travels
throughout Ontario as a bridge
tournament director.
Joel Shapiro, MBA
Accounting Instructor, Ryerson University, Toronto
Abstract: This short article explains the generally accepted
methods of accounting for deferred (future) taxes. Both
timing (temporary) and permanent differences between
accounting income and taxable income are illustrated,
with a comprehensive multi-year problem and solution.
As well, the issues of loss carry-backs, loss carry-forwards,
and tax rate changes are discussed.
Keywords: accounting income, losses, taxable income, tax
rates, timing and permanent differences
Introduction
To anyone who has ever filed an income tax return and
included a payment with it, the idea of deferring the pay-
ment indefinitely sounds like a dream come true. When
accounting for the tax liability of a corporation, in some
cases it can actually be donebut as they say on tele-
vision, some conditions apply. This article will explain
why some income tax liabilities can be deferred, the
conditions that must be present for that to happen, and
how to account for the complications that arise when
companies incur losses and when tax rates change.
Definitions
Deferred taxes (also called future taxes) arise when a
companys accounting income (the income reported on
its fi nancial statements) differs from its taxable income
(the income that is actually subject to income tax,
according to the laws of the jurisdiction in which the
company is incorporated). In most cases, there will be a
differencesometimes a very substantial onebecause,
in most countries, the calculation of income that is sub-
ject to income tax bears no relation to the net income
that must be reported under generally accepted account-
ing principles (GAAP). Recall that GAAP (including vari-
ations such as IFRSInternational Financial Reporting
Standards) mandates the use of accrual accounting,
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 Accounting in a Nutshell 4
not cash-basis accounting. Under accrual
accounting, revenue is normally earned
when the goods are delivered or the ser-
vices performed, not when the cash is re-
ceived from the customer. Expenses are
recorded when incurred, and matched with
the revenues that they helped to earn in
the same period when they are earned
regardless of when the cash is paid. In-
come tax legislation, however, may require
that some revenues and some expenses be
recognized for income tax purposes when
cash is received or paidor sometimes not
at all! Even noncash expenses like depre-
ciation often require different methods
of calculation, and different timing, from
those allowed by GAAP.
These differences between account-
ing income and taxable income are of two
types. Permanent differences are those rev-
enues and gains which are included on the
companys income statement but which
are not taxable at all, and those expenses
and losses which are included on the com-
panys income statement which are never
allowed as tax deductions. Timing differ-
ences (also called temporary differences) are
those items of revenue and expense on the
companys income statement in a specific
period, which will be taxable and deduct-
ible in a later period, or which have already
been taxed and deducted previously. These
even out in the long run, but permanent
differences do not.
As tax laws differ from country to coun-
try, the specific examples of timing and
permanent differences that follow may not
apply to all readers. It is important, how-
ever, to understand and be able to iden-
tify and classify each type of difference
between a companys accounting income
and its taxable income, whatever those
differences might be. The method of rec-
onciling accounting income to taxable in-
come, which will be illustrated below, will
be the same regardless of the specific dif-
ferences that may apply to any particular
corporation.
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One further note before we begin our
comprehensive illustrationwhile public
companies are required to recognize de-
ferred taxes in their financial statements,
small and private companies are often
permitted to ignore the entire subject and
record only the amount that is actually
payable as tax expense in a particular year.
Some Examples of Permanent
Differences
Remember that these may not apply to all
readers, depending on where you live!
In some jurisdictions, the life insurance
premiums that a corporation pays on poli-
cies that cover its top executives are not
allowable (i.e. deductible) for corporate in-
come tax purposes. In such cases, the pro-
ceeds to the corporation of such policies,
upon the death of the executives covered,
are not taxable either. Both are permanent
differences.
Another example of an accounting ex-
pense that is a permanent difference might
be fines and penalties levied by the taxing
authority for infractions, late payments,
and the like.
Dividends received by a corporation
from another corporation have already
been taxed in the payor corporations
hands. Countries that recognize this issue
and do not tax the same income twice al-
low such dividends to be received tax-free.
This is a permanent difference to the com-
pany receiving the dividend income.
There can be many other examples, but
these will be used in the comprehensive il-
lustration that follows.
Some Examples of Timing Differences
For many companies, the most important
timing difference is the difference between
the depreciation recorded in its income
statement and that which is allowed for
income tax purposes. Tax authorities are
not obligated to follow GAAP in prescrib-
ing methods and rates for their purpose,
and they often allow companies far more
 Accounting in a Nutshell 4
depreciation for tax purposes than GAAP
allows. This is because the tax authori-
ties have the aims of their governments
in mindthey might wish to promote cer-
tain industries or sectors of the economy
by allowing companies to write off the cost
of investments in those industries or sec-
tors more quickly. However, as explained
in Accounting in a Nutshell 3Property,
Plant, & Equipment, the total amount of
depreciation that can be taken over the
life of a particular asset is fixed. An assets
depreciable amount is its cost less its es-
timated residual value. Although different
methods of depreciation can allocate an as-
sets depreciable amount differently to dif-
ferent periods, it all must even out in the
end. If tax depreciation exceeds accounting
depreciation in the earlier years of an
assets life, the reverse will be true in the
later years, and the overall total deprecia-
tion will be the same. This is why this is
a timing differenceone accumulated
depreciation figure must always catch up
to the other, and will equal it, over time.
The above can be a very long-term tim-
ing difference. A shorter one might arise
from the accounting for warranty expenses.
These are usually estimated at the time a
product with a warranty is sold, if the war-
ranty is embedded with the product. Tax
authorities might only allow those war-
ranty costs which are actually incurred in
a period to be deducted in that period. This
makes sense from the governments point
of view, since total warranty costs over the
life of a product are clearly estimates and if
they were immediately deductible, compa-
nies would have a clear incentive to overes-
timate these costs and thus minimize their
taxes. Allowing only actual costs incurred
to be deducted reduces this kind of tax
avoidance, but will even out in the long run
once the warranty expires and total actual
costs are known.
A warranty sold separately (like a retail-
ers optional extended warranty, to take ef-
fect after the manufacturers own warranty
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expires) would be unearned revenue for
the seller, as the warranty service has not
yet been provided. Once again, this can be
a timing difference if the tax authorities
disallow this revenue at the start and only
require it to be taxed as it is earnedthat
is, along with the actual warranty costs
incurred over time.
Some jurisdictions may treat other
reserves, such as bad debts, sales returns,
and so on, the same way. Once again, there
can be many other examples of timing dif-
ferences, but these will be used in the com-
prehensive illustration that follows.
Comprehensive Illustration
Assume the following data. Small numbers
are used for the sake of simplicity.
In Year 1, ABC Co. reported income be-
fore tax of $400, and paid income tax of
$120 on that. There were no differences at
all between its accounting income and its
taxable income (both $400).
In Year 2, ABC Co. reported income
before income tax of $1,000. Included in
this figure is depreciation of $50, w
arranty
expense of $70, and a penalty of $10 b
ecause
Year 1s income tax return was filed late.
The company also received a nontaxable
dividend of $30 from an affiliateit is non-
taxable to ABC because the affiliate has
already paid tax on its own income, from
which the dividend was paid. The warranty
cost actually allowed to be deducted is $50,
and depreciation claimed for tax purposes
in year 2 is $80.
Required
Calculate ABC Co.s income tax liability and
expense, both current and deferred, for
Year 2. Assume ABC Co. is subject to a tax
rate of 30 percent.
Solution
Set up a spreadsheet with four columns,
one for the description of the items to be
analyzed, and one for each of the three
terms in the following equation:
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