Current Tax Expense and Deferred Tax Assets and Liabilities

Income tax accounting is tested in FAR because financial reporting income and taxable income are often different. ASC 740 separates the tax provision into a current component based on the tax return and a deferred component based on future tax effects of temporary differences.

The exam issue is usually not tax return preparation. The issue is whether a book-tax difference creates no deferred tax, a deferred tax asset, or a deferred tax liability, and whether the income statement tax provision is current expense, deferred expense, deferred benefit, or some combination.

Current And Deferred Tax Components

Current tax expense or benefit is based on taxable income or loss for the current year. Deferred tax expense or benefit is based on changes in deferred tax assets and deferred tax liabilities.

[ \text{Income tax expense} = \text{current tax expense} + \text{deferred tax expense} ]

[ \text{Current tax expense} = \text{taxable income} \times \text{enacted tax rate} ]

Deferred tax expense generally increases when deferred tax liabilities increase or deferred tax assets decrease. Deferred tax benefit generally arises when deferred tax assets increase or deferred tax liabilities decrease.

Temporary Versus Permanent Differences

The first step is separating permanent differences from temporary differences. Permanent differences affect the effective tax rate but do not reverse in future periods. Temporary differences reverse in future periods and create deferred taxes.

The direction matters. Ask whether the temporary difference will create taxable income or deductible amounts in the future.

Deferred Tax Decision Flow

    flowchart TB
	    A["Identify book-tax difference"] --> B{"Will the difference reverse in future periods?"}
	    B -->|No| C["Permanent difference: no deferred tax"]
	    B -->|Yes| D{"Future effect when it reverses?"}
	    D -->|Future taxable amount| E["Deferred tax liability"]
	    D -->|Future deductible amount| F["Deferred tax asset"]
	    E --> G["Measure using enacted tax rate expected at reversal"]
	    F --> G
	    G --> H["Assess valuation allowance for DTAs"]

This flow prevents a common error: treating every book-tax difference as deferred tax. Only temporary differences and carryforwards create deferred tax assets or liabilities.

Deferred Tax Liability Examples

A deferred tax liability arises when taxable income is lower than book income now because the entity has taken a tax benefit earlier than book accounting recognizes it. The temporary difference reverses later and creates future taxable income.

Common DTL sources include:

• Accelerated tax depreciation that exceeds book depreciation in early years.
• Tax amortization that exceeds book amortization.
• Book revenue recognized before taxable revenue.
• Installment or other timing differences that defer tax to later periods.

Example: book depreciation is $100,000 and tax depreciation is $150,000. Tax deductions exceed book expense by $50,000, so taxable income is $50,000 lower than book income in the current period. If the enacted tax rate is 25 percent:

[ \text{DTL increase} = 50{,}000 \times 25% = 12{,}500 ]

The liability exists because the extra tax deduction taken now will reverse in later years.

Deferred Tax Asset Examples

A deferred tax asset arises when taxable income is higher than book income now because a deduction will be available in a future period, or because a carryforward may reduce future taxable income.

Common DTA sources include:

• Warranty, litigation, or restructuring accruals recognized for book before deductible for tax.
• Allowance for doubtful accounts recognized for book before tax deduction.
• Net operating loss carryforwards.
• Tax credits carried forward.
• Revenue taxed before it is recognized for book.

Example: a company records a $40,000 warranty expense for book purposes, but the amount is deductible for tax only when paid. If the enacted tax rate is 25 percent:

[ \text{DTA increase} = 40{,}000 \times 25% = 10{,}000 ]

The asset exists because the company expects a future tax deduction when warranty costs are paid.

Measuring Deferred Taxes

Deferred taxes are measured using enacted tax rates expected to apply when the temporary differences reverse. Proposed tax law changes are ignored until enacted.

For classified balance sheets, deferred tax assets and liabilities are presented as noncurrent. Current tax receivables and payables remain current when they relate to current tax amounts payable or refundable.

Tax Provision Example

Assume pretax book income is $500,000. Tax depreciation exceeds book depreciation by $80,000. The company also has $20,000 of nondeductible fines. The enacted tax rate is 25 percent, and there are no beginning deferred tax balances.

Step 1: compute taxable income.

Step 2: compute current tax expense.

[ 440{,}000 \times 25% = 110{,}000 ]

Step 3: compute deferred tax liability from the temporary difference.

[ 80{,}000 \times 25% = 20{,}000 ]

Step 4: compute total income tax expense.

The permanent difference affects taxable income and the effective tax rate, but it does not create a deferred tax asset or liability.

Common Exam Pitfalls

Key Takeaways

• Current tax expense is based on taxable income for the current period.
• Deferred taxes arise from temporary differences and carryforwards, not permanent differences.
• Future taxable amounts create deferred tax liabilities.
• Future deductible amounts create deferred tax assets.
• Deferred taxes are measured using enacted tax rates expected to apply when the differences reverse.
• Deferred tax assets require valuation allowance analysis.

Current And Deferred Tax Knowledge Check