Monday, February 11, 2013

Pay Me Now or Pay Me Later: Deferred Taxes, Part 3

You'll recall that a temporary difference is a difference in the tax liability per the books (accounting records) vs. the tax return. Depreciation is a good example to illustrate temporary differences. That's because tax rules on depreciation often differ from how depreciation is posted in the accounting records.


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:
More tax depreciation in year one lowers taxable income and the taxes payable. More tax is owed in future years. You have a deferred tax liability in year one.

Temporary Difference in Year Two:
In year two, tax depreciation is $5,000 less than depreciation on the books ($5,000 for tax, vs. $10,000 per the books). Less tax depreciation means more taxable income now- and a higher tax bill in year two. Assuming a 30% tax rate, taxes would be $1,500 higher in year two. Since the tax return generates a higher tax liability, you post a deferred tax asset. You pay more tax now- and less tax in another period. Since you pay less tax in another period, that has a benefit to you. That benefit is considered an asset.

Temporary Difference in Year Three:
Year 3 is the same situation as year 2. Less depreciation on the tax return means higher income. More income leads to a higher tax bill. That tax bill is higher (once again) by $1,500.

Total Depreciation:
Total depreciation is the same using either method. After all, you're depreciating the same $30,000 truck for both book and tax. Once the truck is fully depreciated, you're all done.

Adding Up the Temporary Differences:
Year 1 had a $3,000 deferred tax liability (See part two). Years 2 and 3 both had deferred tax assets of $1,500. In total- over the three year life of the asset- the liabilities and assets net to zero. The difference is truly temporary. Once the asset is fully depreciated, there is no deferred tax balance for this particular transaction.

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
(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





No comments:

Post a Comment