Example: Let a firm
have sales of $5,000 for each of two years. It estimates that warranty expense to be 2% of
year 1 sales or $100. No warranty is given for year 2 sales. The actual expenditure of $100 to
meet warranty claims was not made until the second year. Assume a tax rate of 40%.
Taxable income for two years appears below.
Year 1
Year 2
Revenue
$5000
$5000
Warranty expense
0
100
Taxable income
5000
4900
Taxes payable
2000
1960
Net income
3000
2940
In this example: year 1 tax expense (on financial statements) is $1,960 although taxes
payable is $2,000. The difference of $40 (taxes paid greater than tax expense) is a deferred
tax asset. In the second year, the temporary difference associated with warranties is reversed
when tax expense of $2,000 is $40 more than taxes payable of $1,960.
c: Describe the liability method of accounting and deferred taxes.
In the US the liability method (SFAS 109) replaced the deferral method (APB 11) of
accounting for tax expense. The deferral method of calculating deferred tax expense using
current tax rates with no adjustment for tax rate changes is now used in only a few countries.
The liability method’s focus is on the measurement of deferred tax assets or liabilities
associated with temporary (reversing) differences in taxable income (IRS) and pretax income
(GAAP). The deferred asset or liability is measured at the tax rate that exists when the
reversing event occurs (usually the current tax rate) and deferred tax expense is the sum
(difference) of the increase (decrease) in the deferred tax liability and taxes payable. The
major difference between the deferral method and liability method is the treatment of changes
in tax rates. The deferral method is unaffected by changes in tax rates while the liability
method adjusts deferred assets and liabilities to reflect the new tax rates.
d: Explain the factors that determine whether a company's deferred tax
liabilities should be treated as a liability or as equity for purposes of financial
analysis.
If deferred assets or liabilities are expected to reverse in the future, then they are best
classified as assets or liabilities. If however, they are not expected to reverse in the future,
then they are best classified as equity.
Deferred taxes in many cases (firm growth, changes in tax laws, or firm operations), may be
unlikely to be paid. Even if they are paid, deferred taxes should be carried at present value
(they are not). If it is determined that deferred taxes are not a liability (i.e., nonreversal is
certain), then deferred taxes is stockholders’ equity. This decreases the debt-to-equity ratio,
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