May be this is a dumb question: I don’t know how a company can use one depreciation method for tax returns and another method for financial statements. I just read, using the accelerated depreciation method results in a lower taxable income and a smaller tax payment. If the firm uses accelerated depreciation method for the tax returns and a straight-line depreciation method for the income statement, doesn’t it bring disparity between the taxes paid in the tax return and what is calculated in the income statement? Somebody please explain the justification of allowing different depreciation method for taxation and financial statements.
kochunni, it’s not a dumb question. You’re correct about the disconnect between depreciation on the tax return vs. the income statement. This disparity results in deferred tax liabilities (DTL), which I guarantee your CFAI books describe in further detail and offer guidance on the analytical implications of DTL. Note that companies can choose to be conservative and use accelerated depreciation on their income statements too, decreasing earnings and the disconnect with tax return depreciation. As for your final question, the CFAI books should also discuss the Modified Accelerated Cost Recovery System (MACRS). Wiki provides some helpful information too. http://en.wikipedia.org/wiki/Macrs
Kochunni, You probably need to get to SS10 – which discusses the implications of Income Taxes and the entire thing with relation to one mode for the Financial statement and another mode for depreciation on the tax statement, and its impact on the Balance sheet would be discussed in much greater detail. And believe me, that chapter needs maybe 4-5 reads before it starts to sink in. CP
Thanks hiredguns & CPK for the great replies. I am yet to cover those readings. I don’t know this is the only way a DTL is created. If it is, can we treat DTL as a measure of the degree of the quality of earnings?
If your question is just “Somebody please explain the justification of allowing different depreciation method for taxation and financial statements.” it’s not that complicated. It’s called a “tax break”. To incent companies to invest in fixed assets the goverment allows for accelerated depreciation methods to be used for tax purposes (faster than might be permitted under to put cash into companys’ pockets in the form of tax savings
Yep, always look in the pork barrel for answers to most accounting questions.
Makes perfect sense Super I.