19. Deferred Taxes

Question 1

If book expense today is less than tax expense today, will taxable income be greater or less than book income?

Answer 1

If tax expense is greater than book expense, then taxable income will be less than book income. That’s because the large tax expense will reduce taxable income below book income. Thus the taxpayer will pay little tax today but will owe more tax in the future for taxable income to eventually equal book income. Thus a deferred tax liability (taxable temporary difference) will be recorded today, representing the taxes that must be paid in the future.

Question 2

If book expense today is greater than tax expense today, will taxable income be greater or less than book income?

Answer 2

If tax expense is less than book expense, then taxable income will be greater than book income. That’s because the small tax expense will increase taxable income above book income. Thus the taxpayer will pay high tax today but will owe less tax in the future in order for taxable income to eventually equal book income. Thus a deferred tax asset (deductible temporary difference) will be recorded today, representing the deductions that can be applied in the future.

Question 3

What are the steps for calculating current tax liability?

Answer 3

1. Pretax book income (i.e. operating and non-operating income)
2. +/- Permanent difference (i.e. the sum of items like muni bond interest, life insurance proceeds, fines or penalties)
3. = Book taxable income
4. +/- Temporary difference (e.g. differences in book/tax depreciation methods, prepaid expenses that are cash for tax, etc.)
5. = Taxable income

Stop and compare book taxable income to taxable income. If book taxable income is greater, then taxable income will be greater in the future, and we must recognize a deferred tax liability for the difference between book and tax. If taxable income is greater, then taxable income will be lower in the future, and we must recognize a deferred tax asset for the difference between book and tax.

1. Multiply taxable income by the current tax rate to get current tax liability

Question 4

What are the steps for calculating tax expense?

Answer 4

1. Calculate current tax liability
2. Record a deferred tax liability or asset for temporary differences
3. Tax expense is the plug in the journal entry:

Dr. Tax expense $100,000

Cr. Current tax liability $75,000

Cr. Deferred tax liability $25,000

OR

Dr. Tax expense $75,000

Dr. Deferred tax asset $25,000

Cr. Current tax liability $100,000

Question 5

How do you calculate the effective tax rate?

Answer 5

The effective tax rate = income tax expense ÷ net income before taxes