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Back to the Basics: Deferred Taxes

May 30, 2018

Over the past few years, numerous changes have affected how deferred taxes are presented and calculated within most entities’ financial statements. As it is, the thought of preparing an income tax provision and recording the appropriate deferred tax assets and liabilities can be daunting, even for certified public accountants. However, there are some basic principles you should know and understand to ensure you’re reviewing your financial statements accurately.

What is a “permanent difference” versus a “temporary difference”?

The first step in knowing the basics of deferred taxes is understanding permanent versus temporary differences. We all know one of the biggest differences in generally accepted accounting principles (GAAP) and tax accounting is when the tax expense is incurred.

A major determinant of this timing is whether the difference will ever reverse. The book-to-tax differences that never end up eliminating are referred to as permanent differences, meaning the differences in the net income recorded for book versus tax purposes will never be equal. Permanent differences include meals and entertainment, fines, municipal bond interest and, in certain instances, goodwill amortization. All of these items can be recorded within GAAP financial statements, thus lowering the net income of the entity; however, for tax purposes, not all of them are recognized as components of calculating taxable income. This causes a permanent difference in the recorded income between book and tax because the difference will never be reconciled.   

On the other hand, temporary differences arise when income is recognized for book and tax purposes in different time periods (hence why these are also known as “timing differences”). However, over a period of time, these differences will eliminate themselves, making book and tax income equivalent.

Due to these timing differences in income, entities must account for the reversal of these differences by utilizing deferred tax assets and deferred tax liabilities. The most common and typically the largest timing differences recorded by entities are net operating loss carryforwards (NOLs) and depreciation on property, plant and equipment, resulting from using accelerated depreciation methods for tax purposes and, typically, a straight-line method for GAAP purposes. Other common temporary differences include receivable allowances, various accruals, prepaid expenses, rental income and warranty accruals. 

So, I have deferred tax assets and liabilities on my balance sheet — now what?

Some exciting and cutting-edge developments have taken shape in the world of deferred tax assets and liabilities (just checking to see if you are still awake). The past few years have been marked by numerous changes that have likely left your head — or your accountant’s head — spinning.

In the past, entities were required to separate deferred income tax assets and liabilities into current and noncurrent amounts in a classified balance sheet. However, this resulted in considerably more work for many entities and was believed to add minimal valuable information to those reading financial statements. In 2015, the Financial Accounting Standards Board (FASB) attempted to simplify the accounting process for these balance sheet items through the release of Accounting Standards Update (ASU) 2015-13, titled “Balance Sheet Classification of Deferred Taxes.” 

To simplify how deferred income taxes were presented, the guidance required that all deferred tax assets and liabilities be classified as noncurrent on a classified balance sheet, as either a net deferred tax asset or a deferred tax liability. This change has not had a significant impact on how deferred tax assets and liabilities are calculated. The information presented on the face of the balance sheet looks a little different, but all details pertaining to deferred tax assets and liabilities are outlined within the notes to the financial statements.

The second major event impacting deferred tax assets and liabilities is related to the Tax Cuts and Jobs Act (“the Act”), which President Trump signed into law on December 22, 2017. In the wake of the Act, many accountants had their work cut out for them, as they began to navigate the reforms and gauge the impact on the financial statements for the entities they served.

Many believed the Act would have minimal impact on financial statements for the year ended December 31, 2017, because the new federal tax rates did not take effect until 2018. However, because gross deferred tax assets and liabilities are tax effected before they are recorded within financial statements, the Act significantly changed those entities’ statements with a calendar year-end occurring after December 22.

What year is this, anyway?

Why were those statements affected? Deferred tax assets and liabilities must be adjusted based on the income tax rate that will be in effect when related temporary differences reverse or when NOLs and tax credits are realized. For instance, prior to the Act, a C corporation may have incurred the maximum federal statutory tax rate of 35% — but now they are subject to a 21% federal rate.

Another example: If the entity had a gross deferred tax asset for NOLs of $10 million prior to the Act becoming law, the entity would have recorded a deferred tax asset within their balance sheet of $3.5 million. But, with this change in the rate, the same $10 million NOL would be reduced to just $2.1 million within the same entity’s balance sheet. Just like that, $1.4 million vanished into thin air — but to where?

As always, the offset to the change in deferred tax assets and liabilities is either additional tax expense or an income tax benefit. As such, many entities that did not have a valuation allowance on their deferred taxes saw a noticeable shift in their deferred income tax expense because of the rate change, despite a consistent current tax expense. This is due to the fact that 2017 taxable income is subject to the 35% corporate federal rate.

The next reasonable question most entities ask is, “How will the Act affect my financial statements in 2018?” Fortunately, due to the deferred taxes update, most of the heavy lifting regarding financial statements is complete. Most entities will now experience a lower effective tax rate, which will impact the current tax expense for financial statements for the year ended December 31, 2018. Additionally, if an entity incurs a NOL on a go-forward basis, they will be able to carry it forward indefinitely but can no longer carry back the loss to the prior two years if they earn positive income in those periods.

What is a valuation allowance?

As mentioned previously, some of the largest deferred tax assets that entities generate relate to NOLs. In many cases, entities navigating the early developmental stages of their organization incur steep losses because they’re actively investing in growth, working to get their product approved or simply waiting for their product to gain traction. NOLs and other deferred tax assets are beneficial to entities that are projecting future profitability because their reversal will reduce the amount of income tax expense in future periods. 

Just like any other asset on the balance sheet, an entity must determine the realizability of the deferred tax assets. If an entity is having difficulty generating a profit over the short and long term, it may need to consider a valuation allowance.

Evaluating whether a valuation allowance is necessary can be an extensive process requiring a significant amount of judgement. Even if the entity is in a net deferred liability position but holds gross deferred tax assets, it should consider a valuation allowance if it is likely (a greater than 50% probability) to not utilize the deferred tax assets. This is important because the reversal of the temporary differences must align with the anticipated future taxable income to be realizable.

Upon identifying the need for a valuation allowance, the entity should determine whether to place a full or partial allowance on the deferred tax assets. Consulting with an experienced certified public accountant can help entities determine if they need a valuation allowance and how best to implement one.

What about pass-through entities?

Business owners consider S corporations, partnerships and other pass-through entities attractive modes of conducting business because they can avoid “double taxation” by passing the income (and thus the tax liability) to themselves. Since these entities do not record income taxes, they certainly don’t have deferred income tax issues, right?

GAAP say no, but in reality, deferred taxes for pass-through entities are real, impactful costs. Read all about it here.

That’s it, in a nutshell!

Any time people hear the word “taxes,” an immediate fear of the unknown sets in. Hopefully, reading through this basic overview has calmed your nerves and provided you with some much-needed simplicity. Of course, there are many layers involved in calculating deferred taxes and valuation allowances. If you feel as though you are in uncharted waters and uncomfortable with the calculation of your provision and deferred taxes, contacting a certified public accountant to navigate you through is always a good move.


Scott Lang, CPA
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