The CPA Journal

Graphical Transaction Model for Deferred Tax Analysis and Accounting

By Joyce S. Allen and John J. Surdick

The asset/liability approach adopted by SFAS 109, Accounting for Income Taxes, requires financial statement preparers to account for temporary differences between the book and tax bases of assets and liabilities. Although SFAS 109 has been in use for approximately 10 years, it remains one of the most complex documents applied in practice. To address these concerns, the authors’ graphical transaction model can be applied to all transactions that have deferred tax implications and enables the user to identify the appropriate financial reporting.

SFAS 109 creates deferred tax account balances by identifying temporary differences between the book and tax bases of assets and liabilities. These temporary differences will result in future deductible or taxable amounts. Multiplying these amounts by the effective tax rate yields the deferred tax asset and liability account balances. Current deferred tax assets and liabilities must be netted for financial reporting. The same treatment must be given to the noncurrent deferred tax assets and liabilities. A valuation allowance should be reported if it is more likely than not that a portion of the tax benefits related to the deferred tax assets will not be realized.

Graphical Transaction Model

Two flowcharts comprise the graphical transaction model as presented in Exhibit 1.

Flowchart A (left panel) is used for future deductible amounts that give rise to deferred tax assets. Flowchart B (right panel) is used for future taxable amounts that give rise to deferred tax liabilities. For example, if a user has identified that a deferred tax asset (Flowchart A) needs to be reported in the financial statements, one would simply proceed through the steps in the flowchart to determine the accounts, amounts, and direction of change for the appropriate adjusting journal entries.

This model is applicable to all temporary differences between the book and tax bases of assets and liabilities as defined by SFAS 109. The two flowcharts greatly facilitate the decision-making process necessary to properly adjust any of the four general ledger accounts that may be potentially affected:

Deferred Tax Asset
Deferred Tax Liability
Other Comprehensive Income
Income Tax Expense, Deferred.

Numerical Data

Three examples illustrate the determination of the accounts, amounts, and direction of change in the adjusting journal entries for deferred income taxes. The first two examples are asset accounts: Available-For-Sale Securities, Current and Property, Plant, and Equipment. The third example is a liability account: Postretirement Benefits Other Than Pensions. Exhibit 2 presents the balance sheet data for these three accounts.

The book basis and tax basis dollar amounts of the three accounts are assumed to be the net of any related contra or adjunct valuation accounts. Therefore, the book basis of the Available-For-Sale Securities account has been adjusted for unrealized gains or losses from marking the securities to market at the balance sheet date. For the Property, Plant, and Equipment account, both the book basis and the tax basis have been reduced by their accumulated depreciation balances [straight-line for financial reporting and the modified accelerated cost recovery system (MACRS) for tax reporting].

The future taxable or deductible amounts and the resulting deferred tax asset or liability are computed from the net of the book basis ending balance and the tax basis. Exhibit 2 also displays the deferred tax analysis, using an average graduated tax rate of 35% to compute the deferred tax account balances.

Example 1: Available-For-Sale Securities, Current

The $3 million net book basis of the securities was measured using the fair value requirements of SFAS 115, whereas the $3.3 million net tax basis is the cost of the securities without fair value adjustment.

Because the book basis is less than the tax basis, a $300,000 future deductible amount was created. The deferred tax asset ending balance of $105,000 is computed based on an average graduated tax rate of 35%.

To determine the appropriate adjusting journal entry for the deferred tax asset, refer to Exhibit 1, Flowchart A. Because the computed deferred tax asset ending balance of $105,000 is greater than the assumed beginning balance of zero (as displayed in Exhibit 3), the user should follow the left-hand side of Flowchart A. The Deferred Tax Asset account has increased by $105,000; therefore, a journal entry is needed to adjust the account. As noted in the flowchart (journal entry 1), the required form of the adjusting journal entry is to increase (debit) the Deferred Tax Asset account by $105,000 and to decrease (credit) the Other Comprehensive Income account by the same amount.

This example assumes there was no beginning balance in the Deferred Tax Asset account; however, it does assume that there was a Deferred Tax Liability beginning balance of $37,000 related to the investment securities. As noted in Flowchart A, this amount must be eliminated (journal entry 3). The required form of the adjusting journal entry is to decrease (debit) the Deferred Tax Liability account by $37,000 and to decrease (credit) the Other Comprehensive Income account by the same amount. At this point, the analysis stops. The financial reporting requirements for comprehensive income are found in SFAS 130.

Example 2: Property, Plant, and Equipment

The $90 million net book basis of the property, plant, and equipment asset was computed in Exhibit 2 using straight-line depreciation and the $80 million net tax basis was computed using MACRS. Because the book basis exceeded the tax basis of the asset, a $10 million future taxable amount was created. The deferred tax liability ending balance of $3.5 million is computed based on an average graduated tax rate of 35%.

To determine the appropriate adjusting journal entry for the deferred tax liability, refer to Exhibit 1, Flowchart B. The first step in using the flowchart transaction model is to compare the computed Deferred Tax Liability ending balance of $3.5 million with the assumed beginning account balance of $2.9 million (as displayed in Exhibit 3).

Because the ending balance is greater than the beginning balance, the user should follow the left side of Flowchart B. The Deferred Tax Liability account has increased by $600,000; therefore, a journal entry is needed to adjust the account. As noted in the flowchart (journal entry 4), the required form of the adjusting journal entry is to increase (debit) the Income Tax Expense-Deferred account by $600,000 and to increase (credit) the Deferred Tax Liability account by the same amount. Since there was a beginning balance in the Deferred Tax Liability account related to the property, plant, and equipment, the analysis stops.

Example 3: Postretirement Benefits Other Than Pensions

Postretirement benefits other than pensions (OPEB), as displayed in Exhibit 2, is an example of a liability that impacts deferred tax accounting. The $700,000 net book basis was accrued using the guidance of SFAS 106. It is assumed that the tax regulations do not permit accrual of OPEB costs, but allow deductions based only on actual funding during the period. Therefore, the assumed tax basis is zero. Since the book basis exceeds the tax basis, a $700,000 future deductible amount has been created. The deferred tax asset ending balance of $245,000 is computed and presented based on a 35% tax rate.

To determine the appropriate adjusting journal entry for this deferred tax asset, refer to Exhibit 1, Flowchart A. Just as in the previous two examples, the first step is to compare the computed Deferred Tax Asset ending balance of $245,000 with the assumed beginning account balance of $285,000 (as shown in Exhibit 3). Since the ending balance is less than the beginning balance, the user should follow the right side of Flowchart A. The Deferred Tax Asset account balance has decreased by $40,000; therefore, a journal entry is needed to adjust the account balance. As noted in the flowchart (journal entry 2), the required form of the adjusting journal entry is to increase (debit) the Income Tax Expense-Deferred account by $40,000 and decrease (credit) the Deferred Tax Asset account by an equal amount. Because there was a beginning balance in the Deferred Tax Asset account related to OPEB, the flowchart analysis stops at this point.

Joyce S. Allen, CPA, is an associate professor of accountancy, and John J. Surdick, PhD, CPA, is the Procter & Gamble Faculty Fellow and a professor of accountancy, both in the department of accounting, Williams College of Business, Xavier University.

Editor:
Thomas W. Morris
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