Pay Me Now of Pay me Later: Deferred Taxes/ Part 2

Part 1 explained permanent and temporary differences, and defined deferred tax liabilities and deferred tax assets. Now, you'll walk through an example of a temporary difference, using depreciation.

Temporary Difference Example: Depreciation
In part 1, you learned that a temporary difference exists when the tax liability for books (accounting records) differs from the tax liability on the tax return.

Why Use Depreciation?
Depreciation is a good example to use for temporary differences. That's because depreciation schedules are often different between a company's accounting records and tax records. Keep in mind: total depreciation ultimately is the same amount using both methods. Assume your business owns a truck with a cost of $20,000. The most you can depreciate the truck is the $20,000. Regardless of which depreciation method you use, once you depreciate $20,000- you're finished! Temporary differences come up, because the annual rate of depreciation differs between the book method and the tax method.

Setting Up The Example:
Assume you own a truck with a cost of $30,000.
   Book Depreciation: Depreciate the truck $10,000 per year for three years.
   Tax Depreciation: Depreciate $20,000 in year one, and $5,000 each year in years 2 and 3.

Temporary Difference in Year One:
  Depreciation Expense: There is $10,000 more depreciation in year one. In other words, the
    year one tax return shows $10,000 more expense. The flip side is that the tax return will have
    $10,000 more income later. That means $10,000 more income- and more tax liability later.

The Tax Rate:
  Assume the tax rate is 30%. $10,000 more income on the tax return also means $3,000 more taxes ($10,000 * 30%) in the future. This future tax liability is a deferred tax liability.

More in the next blog. In the meantime, I hope this video might help:

http://www.youtube.com/watch?v=8FrOhg2PLpQ

Your comments are welcome! For live chats on some of the toughest accounting topics, go to my website listed below.

Thanks!

Ken Boyd

St. Louis Test Preparation

(cell) (314) 913-6529

(email) ken@stltest.net

(website) www.stltest.net

(you tube channel) kenboydstl

(blog) http://accountingaccidentally.blogspot.com/

(twitter) @StLouisTestPrep                         

Author/ Cost Accounting for Dummies (John Wiley and Sons) March 2013