Question

Cremshaw Inc.’s auditors prepared the following detail reconciliation between book and taxable income. Cremshaw’s income tax rate is 21%.

Book income before tax	$650,000
Bad debt allowance	$25,000
Meals ($30,000 * 50%)	$15,000
Tax-exempt interest income	$(20,000)
Wages not paid in 2 ½ months	$45,000
Taxable income	$715,000

Compute the net increase in Cremshaw’s deferred tax assets or liabilities for the year and identify whether deferred tax assets or liabilities increased.

Answer 1

Deferred Tax Assets or liabilities increase/decrease on the basis of timing differences in transactions.

Facts for Discussion 1) In the case of Bad debt allowance, It results in rise of deferred tax assets as it can only be claimed as an expense when it is written off. 2) Cost of Meals will not impact the Defered tax assets/liabilities position as they are not a timing difference but a permanent difference. The tax paid towards this cost cannot be claimed in a future period 3) Tax Exempt Interest Income will also not impact the Defered tax assets/liabilities position as they are not a timing difference but a permanent difference. This interest is exempted now and will not be taxed in the future. 4) Wages not Paid in 2 and half months constitute a timing difference as it could be claimed once payment of such wages are made. Computation of Net Increase or Decrease in Deferred Tax Assets/Liabilities DTA/DTL 1) Bad Debt Allowance Deferred Tax Asset Increase $ 25,000 2) Meals Not Applicable NO CHANGE $0 3) Tax Exempt Interest Not Applicable NO CHANGE $0 4) Wages not Paid Deferred Tax Asset Increase $ 45,000 Reason Can be claimed when written off. No impact on future taxability Income is exempted Can be claimed when actually paid TOTAL $ 70,000 HENCE, NET INCREASE IN DEFERRED TAX ASSETS FOR THE YEAR $ 14,700 ($70,000 x 21%)

Simply put, if we pay more taxes now and can use a TIMING DIFFERENCE like (ADDITIONS OF WAGES NOT PAID AS TAXABLE INCOME) we can claim the taxes paid now by reclaiming the expense as a deduction from taxable income in the future periods. Hence we recognise the extra taxes paid now as a DEFERRED TAX ASSET.

Whereas if we pay less taxes owing to a TIMING DIFFERENCE, we create a DEFERRED TAX LIABILITY which reflects a tax saving now that will reverse in future periods. (EXAMPLE - Higher Depreciation in the Tax code in comparison to the Book Depreciation).