I don't understand Deferred Tax Assets/Liabilities classification

CFA Level I FRA
#1

Schweser Book 3 Page 88 (near the bottom) reads:

‘Deferred taxes are created when the amount of taxes payable exceeds the amount of income tax expense recognized in the income statement. This can occur when expenses or losses are recognized in the income statement before they are tax deductible, or when revenues or gains are taxable before they are recognized in the income statement.’

If taxes payable > Income tax expense recognized on the income statement, then shouldn’t this deferred tax ‘asset’ be classified as a deferred tax ‘liability’ instead… since it means it hasn’t been expensed yet? Please help…

#2

buddy, you and me are in the same boat lol

#3

This might seem counter-intuitive to you (it did to me) but assets roughly correspond to future expenses and liabilities to future revenues. “WHAT?” I can hear you say. But hear me out.

If you spend cash on something that is useful for the current period then it’s an expense. If you spend cash on something that is useful for the future then it’s an asset for now, and you will expense it by depreciating it slowly over the future periods. So initially your balance sheet has less in cash and an equal amount more in assets, and then those assets slowly diminish over time.

Similarly, pre-paid magazine subscriptions are liabilities for the magazine publishers - they have increased cash on hand and an equal increase in liabilities - to make sure that A = L + E.

When taxes payable exceed tax expense, you have less cash than your income statement shows, so you should either have an euqal amount of increased assets or decreased liabilities (or a combination.) But you have no liability in this case - you paid the government more than you should have (so to speak.) So you have an asset that you will offset against a future liability when your tax expense is more than tax payable and your cash outflow is less than it should be. Think of it as a prepaid expense which is an asset.

It’s not a very good asset, because its value depends on the government’s whim. But that’s a separate topic.

#4

I think there is a youtube video by David Harper on this. It really helped me 3 years ago… Give it a shot if you have time…

#5

It’s not as complicated as you think. 1Recho did a good job explaining it.

Every problem boils down to this. What income tax did I report on my taxes? Was it higher or lower than the financial statement? If it is lower than the financial statement, I am going to owe taxes in the future. If it was higher than the financial statement, I will not have to pay those taxes in the future. Having to pay taxes is a payable (liability). Taxes already paid is a prepaid (Asset).

It is 3:22 AM in the morning, so there is a chance I switched the above. But just break it down into a step by step process to think of it. That helps it become much clearer.

#6

Understanding deferred taxes is probably the hardest thing in whole of accounting arena. Probably next comes inventory valuation. Luckily a bit of intuition would help.

Imagine you had to pay taxes as per your profits reported in the Income Statement. Now, you actually can’t pay your taxes based on your Income Statement profit because the tax laws says otherwise. So you have another Income Statement prepared under Tax Laws - let’s call it Income Statement (T).

If the profit shown by the Income Statement (T) is > profit under Income Statement, then the tax payable (on T’s profits) will be greater than income tax expense (tax expense under your regular Income Statement).

So how do you bridge the gap? Enter Deferred tax expense. DTE + income tax expense = Taxes Payable.

The corresponding Balance Sheet entry for DTE is DTL. You may understand this through the accounting equation. DTE reduces Equity, therefore to balance the accounting equation (A = L + E) you increase L.

You can work the other way as well. Hope this helps. Or did I just complicate it a lot more?

#7

Think about taxes payable as a cash flow and tax expense is what you owe. If you pay more then you owe, you get a “tax credit” which is classified as DTA. Similarly, if you pay less than you owe (taxes payable is less than tax expense), you will have to pay more in the future, the difference is classifed as DTL. Does this help?

#8

Thanks a lot. Yes, your likening to the deferred tax asset as a prepaid expense asset really helped. Great answers all round, really appreciate it.

#9

Try this:

First know that these items arise due to the differences in accounting methods used to complete the financial statements, and the accounting methods used to actually file a tax return with the IRS. For example, on a given PPE asset item, for IRS reporting we may assume a depreciation schedule of: 50% 35% 15% and no salvage value. On the other hand for financial reporting, we may simply use a straight line depreciation of: 33% 33% and 33%. You can illustrate this on a spread sheet very simply in about 5 minutes to see how it works.

Here’s a simple example using the above numbers;

Equipment original cost = $100 ** Revenue = $250 ** Tax rate = 30% (assume no other expenses)

IRS reporting YR1 YR2 YR3

Revenue 250 250 250

Depreciation exp 50 35 15

EBT 200 215 235

Taxes owed/paid 60 64.5 70.5

Financial Reporting

Revenue 250 250 250

Depreciation exp 33.3 33.3 33.4

EBT 216.7 216.7 216.6

Income tax prov. 65.01 65.01 64.98

*Notice in YR 1, we paid less in taxes to the IRS than what we show as our income tax provision on our income stmt. This means we will eventually have to pay out MORE in taxes in the future than what our income statement will show because these differences work out to 0. As a result, this company would record a deferred tax liability in YR 1 of (65.01 - 60) 5.01.

In YR 2, we paid slightly less still, and would add to our deferred tax liability, which at end of yr 2 would be (5.01 + (65.01 - 64.5)) 5.52.

In YR3, the final year of our asset, notice we actually pay the IRS MORE than what we record on our income stmt. A difference of (70.5 - 64.98) = 5.52. This would reduce our deferred tax liability back to 0.

The important concept to know is that they result because of a difference in depreciation schedules used by the IRS vs. FASB. Further note that the differences are temporary and will work out to 0 in the end, so if you actually pay less in taxes than what you say you paid, you will eventually have to pay more than what you say you paid (liability).

Hope this helps.

Donnie

#10

Try to keep the logic simple. Companies maintain 2 types of reports 1. Tax Forms( For the purpose of paying tax) 2. Income statement (For investors). So the way the companies report their operations in these two reports can cause deffered tax. So it can be either deffered tax asset or deffered tax liability.

  1. Deffered Tax asset : In this case the company pays more tax in the tax form than the Income statement. So the company is paying more than what it is supposed to pay. So this excess amount will be used by the company in the future. So this excess is treated as asset by company.

  2. Deffered Tax Liability : In this case the company pays less tax in the tax form than the Income statement. So the company is paying less than what it is supposed to pay. So the company owes this amount of tax money. So the company treats this amount as liability as it has to pay in the future.

If you want to understand why this difference is caused in these two forms , you have to go more deeper. The main elements that cause this differences are 1. Amortization or depreciation methods used.

  1. Revenue recognition methods used.