The income tax expense or benefit includes not only current income taxes, but also a deferred income tax component. This deferred portion is calculated by analyzing the change in the company’s total net deferred income tax asset or liability from the beginning to the end of the reporting period. Similar to the calculation of current income tax, the calculation of deferred taxes should be done on a tax jurisdiction-by-tax jurisdiction basis.
A deferred tax asset is determined by identifying the cumulative deductible temporary differences at the end of the reporting period. These cumulative differences should represent either:
- Future tax deductible items that have not been recognized, such as an allowance for bad debts expensed on the books currently but not deductible for tax purposes until actually written off;
- Future book income items that will not be recognized for tax purposes, such as that portion of deferred revenue that represents future book income that has already been recognized for tax purposes when cash was received.
Also included in cumulative deductible temporary differences are any loss carryforward amounts. Once the cumulative deductible temporary differences are quantified, each is then multiplied by the enacted tax rate expected to apply when the temporary difference reverses. Tax credit carryforwards are then added to the deferred tax asset amount at tax-affected rates.
The same process is used to determine a deferred tax liability, with the exception that the cumulative taxable temporary differences are identified at the end of the reporting period. A taxable temporary difference can be either:
- Future book expenses that will not be recognized for tax purposes, such as a future book depreciation expense that will not be recognized for tax purposes where tax depreciation has already been deducted under an accelerated method;
- Current book income items that will be recognized in a future period for tax purposes, such as book income from an installment sale that can by deferred to a future period for tax purposes.
The quantified cumulative taxable temporary differences are then multiplied by the enacted tax rate expected to apply when the temporary difference reverses to determine the amount of the deferred tax liability.
Once the net deferred tax asset or liability is determined in each tax jurisdiction, the change from the beginning balance must be reviewed to calculate the amount of deferred income tax expense or benefit. This change will primarily be caused by current year book-tax temporary differences that have been identified earlier in the current income tax calculation. Other possible factors that can affect the balance are return to provision adjustments affecting temporary items; purchase accounting adjustments; a change in tax rates used in the analysis; and foreign currency translation adjustments. Not all changes to deferred income tax assets or liabilities result in deferred income tax expenses or benefits. Some changes may, for example, affect goodwill, equity, or other comprehensive income.
To avoid errors in calculating the ending cumulative differences, it is advisable to perform a book versus tax basis comparison of each of the items. To ensure completeness, it is recommended that a full tax basis balance sheet be prepared and compared to the existing book basis balance sheet to identify all cumulative temporary differences. This comparison will verify the amount of ending cumulative temporary difference calculated. Just rolling forward the existing beginning balances using current year differences without performing the book versus tax basis comparison can produce unexpected errors. These errors might not be identified for several years and could potentially result in a restatement of the financial statements once discovered.
For question regarding ASC-740 provision matters, please contact Daniel DeLau at 720-227-0065 delau@taxops.com John Monahan at 720-227-0064 or jmonahan@taxops.com .
