Deferred Tax Assets and Liabilities

Learn how deferred tax assets and liabilities are created, measured, and reported under US GAAP for the Financial Accounting and Reporting (FAR) CPA Exam.

Introduction to Deferred Tax

Financial accounting and tax accounting serve fundamentally different purposes. Financial accounting provides useful information to investors, creditors, and other external stakeholders under US GAAP. In contrast, tax accounting determines tax liabilities under the Internal Revenue Code. Because these two systems operate under different sets of rules, the timing of revenue and expense recognition often differs. This divergence creates a need for deferred tax accounting.

A deferred tax asset or liability arises from temporary differences. These are differences between the financial statement carrying amount of an asset or liability and its tax basis. When these differences reverse in future years, they create taxable or deductible amounts. Understanding how to calculate and report these differences is essential for corporate financial reporting. Candidates preparing for professional accounting credentials must master these concepts. You can learn more about the structure of the exam by visiting CPA exam sections.

Temporary vs. Permanent Differences

To account for deferred tax properly, you must distinguish between temporary and permanent differences. Temporary differences are items that enter into the determination of pretax financial income in one period but enter into taxable income in another period. These differences eventually reverse over time. Examples include depreciation methods, warranty liabilities, and bad debt provisions.

In contrast, permanent differences do not reverse. Permanent differences affect the current year's effective tax rate but do not result in deferred tax assets or liabilities. Examples of permanent differences include tax-exempt municipal bond interest and non-deductible fines. Because these items never impact taxable income, they do not create future tax consequences.

The Internal Revenue Service requires corporations to reconcile these items. Specifically, IRS Schedule M-3 requires corporations to reconcile book income to taxable income. This reconciliation process explicitly distinguishes between temporary differences and permanent differences. Candidates can review the core testing areas for these topics in the CPA exam blueprints.

Deferred Tax Assets and Valuation Allowances

A deferred tax asset represents a future tax benefit. It arises when a company pays more taxes today than it recognizes as tax expense under US GAAP. This situation occurs when expenses are recognized on the income statement before they are deductible on the tax return. It also occurs when revenue is taxed before it is recognized on the income statement. Net operating loss carryforwards also create deferred tax assets.

However, a company cannot always guarantee it will realize these future tax benefits. To realize a deferred tax asset, the company must generate sufficient future taxable income. Under US GAAP, companies must evaluate the recoverability of these assets. A valuation allowance must be established for deferred tax assets if it is more likely than not that some portion or all of the deferred tax assets will not be realized.

The term "more likely than not" means a likelihood of more than 50 percent. If a company determines that it is more likely than not that it will not realize the asset, it must reduce the deferred tax asset through a valuation allowance. This adjustment directly impacts the income tax expense on the income statement. To practice calculations related to valuation allowances, candidates can use the free CPA practice test.

Deferred Tax Liabilities and Balance Sheet Classification

A deferred tax liability represents a future tax payment. It arises when a company recognizes tax expense on the income statement before it pays the tax to the government. This situation typically occurs when revenues are recognized for financial reporting before they are taxed. It also occurs when expenses are deducted for tax purposes before they are recognized on the income statement. A common example is using accelerated depreciation for tax purposes and straight-line depreciation for financial reporting.

Proper presentation of these items on financial statements is highly regulated. Under US GAAP, deferred tax assets and liabilities must be classified as noncurrent on a classified balance sheet. Companies are not permitted to classify any portion of deferred taxes as current assets or current liabilities. This rule simplifies balance sheet presentation.

Additionally, companies must net deferred tax assets and liabilities within the same tax jurisdiction. The resulting net amount is presented as a single noncurrent asset or noncurrent liability. Candidates looking for strategies to memorize these presentation rules can explore CPA study tips.

Deferred Tax on the CPA Exam

Deferred tax accounting is a major topic on professional accounting examinations. The Financial Accounting and Reporting (FAR) section of the US CPA Exam tests candidates on deferred tax concepts. Candidates must demonstrate proficiency in identifying temporary differences, calculating deferred tax assets and liabilities, and determining the need for valuation allowances.

The exam also covers net operating loss carryforwards and their tax effects. Candidates must be prepared to calculate the current and deferred portions of income tax expense. They must also understand how to record the journal entries to establish or adjust deferred tax accounts.

To prepare effectively, candidates should practice multiple-choice questions and task-based simulations. Utilizing CPA practice questions can help reinforce these complex accounting mechanics. Furthermore, performing a weakness analysis` can identify specific areas where a candidate needs additional study. Mastering these concepts ensures readiness for both the exam and real-world corporate reporting challenges.

Journal Entries and Practical Examples

To fully grasp deferred tax, candidates must understand the underlying journal entries. When a temporary difference creates a deferred tax asset, the company records a debit to the deferred tax asset account and a credit to deferred tax benefit (which reduces total income tax expense). Conversely, when a temporary difference creates a deferred tax liability, the company records a debit to deferred tax expense and a credit to the deferred tax liability account.

When a valuation allowance is established or increased, the company records a debit to income tax expense and a credit to the valuation allowance account. This allowance acts as a contra-asset account, reducing the carrying value of the deferred tax asset on the balance sheet. If circumstances change and the company determines it is more likely than not that the deferred tax asset will be realized, the valuation allowance is reversed with a corresponding credit to income tax expense.

These practical applications are frequently tested in task-based simulations. Candidates must be comfortable navigating tax rate changes as well. If tax laws change and a new tax rate is enacted, companies must adjust their deferred tax assets and liabilities in the period of enactment. The effect of the adjustment is recognized in income from continuing operations.

Frequently asked questions

What is the difference between a temporary and a permanent tax difference?

Temporary differences arise when the timing of revenue or expense recognition differs between tax and financial reporting, and they eventually reverse over time. Permanent differences are items that are recognized for either tax or financial reporting, but never both, meaning they do not reverse and do not create deferred tax assets or liabilities.

Where are deferred tax assets and liabilities classified on the balance sheet?

Under US GAAP, all deferred tax assets and liabilities must be classified as noncurrent on a classified balance sheet. They are also netted by tax jurisdiction and presented as a single net noncurrent asset or liability.

When is a valuation allowance required for deferred tax assets?

A valuation allowance is required if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized.

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