Question 3: Answer each of the following questions in completing sentences in pr

Question

Question 3: Answer each of the following questions in completing sentences in proper English, restating the question as part of the answer.

Please use your own words, thanks, I have viewed several online sources but find they are not helpful.

If you can, please explain your answer to help me understand, I really want to learn! Thanks!

1. Why do temporary differences between GAAP income and taxable income require recording of deferred tax assets and liabilities but permanent differences do not?

2. When a company records a deferred tax asset, what additional analysis and possible accounting procedure (journal entry) must be done that is not done with deferred tax liabilities? How does this affect the income statement and balance sheet?

3. What is the two-step process for classifying deferred tax assets and liabilities as either current or non-current for balance sheet reporting purposes?

Explanation / Answer

1)

Permanent differences occur only for the tax year in which they occur. Temporary differences occur over several years, ending when the differences reverse. Forms of income that lead to permanent differences include:

Other differences between financial and tax accounting result because of different rules affecting the capitalization of certain business expenditures, such as start up costs and inventory costs. Other differences arise because of different rates of depreciation, amortization, or depletion for some assets. For instance, if a business uses §179 expensing, then it can deduct the whole cost of an asset when it is acquired. However, because it's actual useful life is longer than 1 year, financial accounting would depreciate the item according to its expected useful life. For many businesses that carry an inventory, a recurring source of differences results from uniform capitalization rules, which require that many expenses that are incurred to produce or acquire property for resale must be capitalized rather than expensed, such as the administrative costs allocable to the production or acquisition of inventory.

Because financial accounting represents the true financial picture of the business, there must be some way of recognizing tax benefits and liabilities that will occur in a future year because of accounting entries in the present tax year, because benefits must be recorded when the right to the benefit occurs even if it is not received and expenses must be recorded when the liability arises even if the expense is paid in a later year. Temporary differences between book and taxable income give rise to accrued tax benefits and liabilities. Because permanent differences only affect the current tax year, tax assets or liabilities arising from permanent differences do not accrue. The deferred tax asset account and the deferred tax liability account are the accounts used in financial accounting to record accrued tax assets or liabilities.

A deferred tax asset is the payment of tax on taxable income that exceeds book income because of temporary differences for the tax year. So if temporary differences cause taxable income to be $10,000 greater than book income for a given tax year, then the business will be able to deduct that $10,000 in a later tax year, since the tax has already been paid on the amount. Thus, a deferred tax asset is much like the overpayment of tax that the business will recoup in a later year. A deferred tax liability arises when book income is greater than taxable income because of temporary differences, in which case the business will have to pay the tax on the difference in incomes in a later tax year. Hence, a deferred tax liability is much like an underpayment of tax that will become payable in a future year. Increases in deferred tax assets decrease the corporation's future tax liability, whereas deferred tax liabilities increases it.

2)If the income tax expense in the income statement is smaller than the current income tax liability the difference is called adeferred tax asset.

Deffered tax asset account debit

Profit and loss account credit

3)

The evaluation of a tax position in accordance with this Interpretation is a two-step process. The first step is recognition: The enterprise determines whether it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. In evaluating whether a tax position has met the more-likely-than-not recognition threshold, the enterprise should presume that the position will be examined by the appropriate taxing authority that would have full knowledge of all relevant information. The second step is measurement: A tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

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