# Qns on Analysis of Income Taxes

I understand how Deferred Tax Liabilities are created, when Income tax expense greater then Taxes payable… My Qns is: How the Deferred Tax Liabilities is being reflected in the Accounting Equation A = L + E Since DTL can be considered as Liabilities, i would assume the left hand side(L) of the equation is increased… How is A affected? or A is not affected but there are some decrease in other L or E so that the equation is still equal Thanks

You’re basically splitting a liability into two: income taxes payable and deferred taxes. Retained earnings will not be affected because you will still report your tax expense regardless of the type of tax reporting you use. When, for instance, you report a tax expense of \$4,000 (Dr), but only have a tax liability of \$2,000 (Cr), you will offset the expense with the creation of the \$2,000 deferred tax liability (Cr). In essence, you’re taking \$4,000 away from equity (via expense) and adding it to liabilities, so the total balance sheet equation is unchanged. Assume there were no differences in both taxable income and net income, and you owed \$4,000. Then you would have to earmark \$4,000 in cash to cover that full liability. But if, due to differences in reporting, you created a deferred tax liability, you would only need \$2,000 from your cash to satisfy current taxes. That extra \$2,000 in cash (or the asset side of the B/S) that you are owing is offset by the future deferred tax liability, which should–note that I don’t say will–eventually reverse. Hope that helps.

gdiddy Wrote: ------------------------------------------------------- > You’re basically splitting a liability into two: > income taxes payable and deferred taxes. > > Retained earnings will not be affected because you > will still report your tax expense regardless of > the type of tax reporting you use. > > When, for instance, you report a tax expense of > \$4,000 (Dr), but only have a tax liability of > \$2,000 (Cr), you will offset the expense with the > creation of the \$2,000 deferred tax liability > (Cr). In essence, you’re taking \$4,000 away from > equity (via expense) and adding it to liabilities, > so the total balance sheet equation is unchanged. > > Assume there were no differences in both taxable > income and net income, and you owed \$4,000. Then > you would have to earmark \$4,000 in cash to cover > that full liability. But if, due to differences > in reporting, you created a deferred tax > liability, you would only need \$2,000 from your > cash to satisfy current taxes. That extra \$2,000 > in cash (or the asset side of the B/S) that you > are owing is offset by the future deferred tax > liability, which should–note that I don’t say > will–eventually reverse. > > Hope that helps. I am no expert, but somehow I think retained earnings is reduced by DTL. On income statment, interest expense = tax payable + change in DTL - change in DTA. Ignore DTA here. If DTL is created or increased, interest expense is higher, thus reduce net income and retained earnings. So I think DTL is balanced by equity (retained earnings). Am I right?

hopetobeat is correct. The offset to DTA/DTL, or regular taxes payable/receivable is pretty much always income tax expense on the income statement, which at period end is closed into retained earnings on the balance sheet.

Think of the journal entries when you create a deferred tax liability: Debit Taxes Expense Credit Taxes Payable Credit Deferred Tax Liability Taxes expense will always be taxes expense, and therefore a reduction in equity. So in essence, yes, you are reducing equity (via expense, as taxes expense or any expense is a reduction in equity). But a reduction in equity either means a reduction in assets or an increase in liabilities. In this case you are reducing equity to add to liabilities. Hence the creation of a deferred tax liability.

hopetobeat Wrote: ------------------------------------------------------- > If DTL is > created or increased, interest expense is higher, > thus reduce net income and retained earnings. So > I think DTL is balanced by equity (retained > earnings). Am I right? Where are you getting interest expense from? How does a deferred tax liability generate interest expense?

I think he meant to say Tax Expense, and wrote interest expense by mistake. In the post above: interest expense = tax payable + change in DTL - change in DTA. Ignore DTA here. If DTL is created or increased, interest expense is higher, thus reduce net income and retained earnings interest expense should be replaced by “Tax Expense” instead. CP

But I think we’re falling in the trap which came first, the chicken or the egg. Yes, deferred tax assets and liabilities are born out of a mismatch between taxes expensed and taxes owed. And yes, taxes expense can be derived from computing the net changes in the deferred assets/liabilities and coupling those changes with taxes payable to determine tax expense (net increases in deferred liabilities implies a higher expense, and net increases in deferred assets imply a lower expense). The key, however, is tax expense will always be tax expense: it’s the taxes purportedly owed under the financial numbers provided to investors. If this number is above what’s actually owed, then you generate a liability; if it’s less, then you have a prepaid asset. The opening post asked what effect do deferred taxes liabilities have on the balance sheet. Actually, you don’t really have to go into too much detail as the answer is contained in the statement itself: deferred liabilities imply greater liabilities. Seems like a crude answer, but that’s basically what’s happening. On a side note, I really hate FAS 109…

thanks for all the responses i am clearer now… i have no accounting background and i am always quite confused about how the accounting equation (A=L+E) get balanced… on more qns: can i say that when Deferred Tax Assets is created, the Asset side of the equation is: - X amount Cash is decreased -DTA is increased by the same X amount No change to the L+E side of the equation

Quantum, Not sure why you are trying to map everything to the A = L + E equation. Agreed, that is one of the ways in which you can understand it, but when it comes to taxes, believe me, there is much more testable material than trying to fit things into the A=L+E equation. Think more in terms of scenarios where a DTA is created. On the Income statement you book e.g. Warranty Expense in the period the items are sold. On the Tax return, you can only book actual Warranty Expense. So Accrued Warranty Expense > Actual Warranty Expense. In future the warranty expense would increase. Tax expense in the future would be lower. Another situation for creation of DTAs On Income statement --> you accrue Bad Debt Expense by the Allowance method. On the Tax statement - you can only book “direct write offs”. This means you are deferring an expense / deduction to the future. So you create a DTA. So it is not necessary that Cash comes down. Some form of Accrued expense account comes down (on the asset side), while the DTA goes up. Yes both are on the Asset side of the equation, but not necessarily Cash. Hope this helps, CP

Again let’s assume an illustration… Your tax expense is \$4,000; however, you really owe the IRS \$6,000 So here are the journal entries: …Dr…Cr Taxes Payable…\$6,000 Tax Expense…\$4,000… Prepaid Taxes…\$2,000… Now, think of this intuitively: you reduce equity by \$4,000 (via expense), but increase liabilities by \$6,000. The net change in L+E is +\$2,000. Therefore, in order for the accounting equation to balance, you must increase assets by \$2,000 (hence the prepaid asset). When it comes time to pay taxes, cash will be decreased to satisfy the taxes due/payable… …Dr…Cr Taxes Payable…\$6,000… Cash…\$6,000 Remember, the prepaid asset is essentially “stored” value that will be written off when the taxes reverse. So, say in the final year, your expenses are finally counted in your tax statements and you owe the IRS \$2,000 instead. …Dr…Cr Tax Expense…\$4,000… Taxes Payable…\$2,000 Prepaid Taxes…\$2,000 Come time to payoff your taxes, you’re only using \$2,000 in cash. But wait, the expense is \$4,000. So if we reduce equity by \$4,000, and only increase liabilities by \$2,000, the net L+E change is -\$2,000. That requires a \$2,000 reduction in the asset side of the balance sheet. Hence the removal of the deferred asset. Hope that helps.