Temporary Differences

• Differences between Income Tax Expense on the financial statements

and Income Tax Payable to the government that will reverse over time
• Income Tax Expense = Adjusted Pre-tax income x statutory tax rate
– Adjusted Pre-tax income based on GAAP rules and excludes permanent
differences
– For convenience, I will say Pre-Tax Income instead of Adjusted Pre-Tax Income
– Expense on income statement
• Income Tax Payable = Taxable income x statutory tax rate
– Taxable income based on tax code rules
– Paid to the government
• Temporary Differences are stored in Deferred Tax Assets and
Liabilities
• We will use 35% as the statutory tax rate in all calculations unless
otherwise noted
KNOWLEDGE FOR ACTION
Deferred Tax Liabilities
• Arise from temporary differences where, initially, tax rules require
bigger expenses or smaller revenues than GAAP
– Pre-tax income > Taxable income
– Income tax expense > Income tax payable
• In the future, GAAP will require bigger expenses or smaller revenues
than tax rules
– Pre-tax income < Taxable income
– Income tax expense < Income taxes payable
• The Deferred Tax Liability represents the obligation to make higher
tax payments in the future

KNOWLEDGE FOR ACTION

Deferred Tax Liabilities
• Arise from temporary differences where, initially, tax rules require
bigger expenses or smaller revenues than GAAP
– Pre-tax income > Taxable income
– Income tax expense > Income tax payable
• In the future, GAAP will require bigger expenses or smaller revenues
than tax rules
– Pre-tax income < Taxable income
– Income tax expense < Income taxes payable
• The Deferred Tax Liability represents the obligation to make higher
tax payments in the future
Today
Dr. Income Tax Expense (+E) 100
Cr. Deferred Tax Liability (+L) 10
Cr. Income Tax Payable (+L) 90

KNOWLEDGE FOR ACTION

Deferred Tax Liabilities
• Arise from temporary differences where, initially, tax rules require
bigger expenses or smaller revenues than GAAP
– Pre-tax income > Taxable income
– Income tax expense > Income tax payable
• In the future, GAAP will require bigger expenses or smaller revenues
than tax rules
– Pre-tax income < Taxable income
– Income tax expense < Income tax payable
• The Deferred Tax Liability represents the obligation to make higher
tax payments in the future
Today
Dr. Income Tax Expense (+E) 100
Cr. Deferred Tax Liability (+L) 10
Cr. Income Tax Payable (+L) 90

KNOWLEDGE FOR ACTION

Deferred Tax Liabilities
• Arise from temporary differences where, initially, tax rules require
bigger expenses or smaller revenues than GAAP
– Pre-tax income > Taxable income
– Income tax expense > Income tax payable
• In the future, GAAP will require bigger expenses or smaller revenues
than tax rules
– Pre-tax income < Taxable income
– Income tax expense < Income tax payable
• The Deferred Tax Liability represents the obligation to make higher
tax payments in the future
Today Future
Dr. Income Tax Expense (+E) 100 Dr. Income Tax Expense (+E) 90
Cr. Deferred Tax Liability (+L) 10 Dr. Deferred Tax Liability (-L) 10
Cr. Income Tax Payable (+L) 90 Cr. Income Tax Payable (+L) 100

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books)
Year Depr. Pre-tax Inc. Tax
EBTDA Exp. Income Exp.
2010 100,000 40,000 60,000 21,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000

KNOWLEDGE FOR ACTION

 Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000

Deferred Tax Liab. (L)

• 2010 Journal entry 14,000 ‘10
Dr. Income Tax Expense (+E) 21,000
Cr. Deferred Tax Liability (+L) 14,000
Cr. Income Tax Payable (+L) 7,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000
2011 100,000 40,000 60,000 21,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000
2011 100,000 40,000 60,000 21,000 100,000 27,000 73,000 25,550

KNOWLEDGE FOR ACTION

 Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000
2011 100,000 40,000 60,000 21,000 100,000 27,000 73,000 25,550
Deferred Tax Liab. (L)
• 2011 Journal entry 14,000 ‘10
Dr. Income Tax Expense (+E) 21,000 ‘11 4,550

Dr. Deferred Tax Liability (-L) 4,550

Cr. Income Tax Payable (+L) 25,550

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000
2011 100,000 40,000 60,000 21,000 100,000 27,000 73,000 25,550
2012 100,000 40,000 60,000 21,000

KNOWLEDGE FOR ACTION

Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000
2011 100,000 40,000 60,000 21,000 100,000 27,000 73,000 25,550
2012 100,000 40,000 60,000 21,000 100,000 13,000 87,000 30,450

KNOWLEDGE FOR ACTION

 Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000
2011 100,000 40,000 60,000 21,000 100,000 27,000 73,000 25,550
2012 100,000 40,000 60,000 21,000 100,000 13,000 87,000 30,450
Deferred Tax Liab. (L)
• 2012 Journal entry 14,000 ‘10
Dr. Income Tax Expense (+E) 21,000 ‘11 4,550
’12 9,450
Dr. Deferred Tax Liability (-L) 9,450
0
Cr. Income Tax Payable (+L) 30,450

KNOWLEDGE FOR ACTION

 Example: Deferred Tax Liabilities
• Brey Co. buys a $120,000 machine on 1/1/2010. For book purposes, it
estimates that the machine will have a 3-year life with no salvage
value. For tax purposes, the MACRS schedule dictates a depreciation
schedule of $80,000, $27,000, and $13,000 in the three years.
Straight Line Method (books) MACRS Method (tax)
Year Depr. Pre-tax Inc. Tax Depr. Taxable Inc. Tax
EBTDA Exp. Income Exp. EBTDA Exp. Income Pay.
2010 100,000 40,000 60,000 21,000 100,000 80,000 20,000 7,000
2011 100,000 40,000 60,000 21,000 100,000 27,000 73,000 25,550
2012 100,000 40,000 60,000 21,000 100,000 13,000 87,000 30,450
120,000 63,000 120,000 63,000

• Temporary difference:
– Timing of depreciation expense and tax expense is shifted across time
– But totals are the same between books and taxes

KNOWLEDGE FOR ACTION