Deferred Income Tax Liability
Your tax authority determines how you account for temporary differences in expenses between the corporate book and the tax book. One of the largest temporary differences is depreciation expense. For example, in the corporate book, you may depreciate assets using a straight-line method. For tax purposes, however, you can often use an accelerated depreciation method to take more depreciation in the early years of an asset's life and less in the later years. The higher depreciation expense in the early years reduces your taxes at that time. Your tax authority may require that you create a liability on your balance sheet to account for the tax payment delay. Deferred depreciation, the temporary difference in depreciation expense between the corporate book and the tax book, is a part of this liability.
To determine the depreciation contribution to your tax liability, calculate the two types of depreciation differences that exist between the corporate book and the tax book. Some differences are temporary; they occur when you use different depreciation methods in the corporate and the tax books. The depreciation calculation reduces, and eventually eliminates, the temporary difference as the asset becomes fully reserved.
Permanent differences occur when you define different recoverable costs for an asset in the corporate book and the tax book. Permanent differences arise from differences in cost or salvage value, or the effect of investment tax credit basis reductions. The difference is permanent because you never eliminate it through depreciation. The following equations describe how permanent differences affect the recoverable cost in the corporate book and the tax book:
Corporate Recoverable Cost = Corporate Cost - Corporate Salvage Value
Tax Recoverable Cost = the lesser of (Tax Cost - Tax Salvage Value - ITC Basis Reduction Amount) or Depreciation Cost Ceiling, if any
You can use these calculations to determine your FASB 109 tax liability under United States tax law.
You can determine the contribution that depreciation makes to your tax liability by projecting depreciation expense for future years and then adjusting depreciation expense for permanent differences. To determine your future income tax liability, you can:
1. Project annual depreciation expense in the corporate and tax books.
2. Determine the recoverable cost in the corporate and tax books as of the end of the fiscal year.
3. Adjust the depreciation projection values to account for the permanent differences in depreciation.
For each projected year, you need three values: corporate depreciation expense, tax depreciation expense, and adjusted tax depreciation expense. You take the corporate and tax depreciation expense values directly from the Depreciation Projection Report. To determine the adjusted tax depreciation expense, you calculate the ratio of the corporate recoverable cost to the tax recoverable cost. You take the corporate and tax recoverable cost values directly from the Recoverable Cost Report. You then multiply the ratio by the tax depreciation expense.
Adjusted Tax Depreciation Expense = Tax Depreciation Expense X (Corporate Recoverable Cost/Tax Recoverable Cost)
You can use the difference between the corporate depreciation expense and the adjusted tax depreciation expense for each projection year as the net amount in your tax liability calculations.
Use this information to determine the tax liability depreciation contribution net of the permanent differences.
Example: Future Income Tax Liability Calculation
You have closed your corporate and tax books for your 1992 fiscal year. You run the Depreciation Projections program to project depreciation for five years, beginning with fiscal year 1993. The Depreciation Projection Report prints the following results:
Next, you run the Recoverable Cost Report for the last period of your 1992 fiscal year to determine the recoverable cost in both depreciation books.
Corporate Recoverable Cost = 65,000
Tax Recoverable Cost = 75,000
You then calculate the ratio of the corporate recoverable cost to the tax recoverable cost.
Corporate Recoverable Cost/Tax Recoverable Cost
= 65,000/75,000
= 0.867
Now you have the information you need to adjust the tax depreciation projections. Using the ratio 0.867, you can calculate the adjusted tax depreciation expense:
You now can determine the tax liability depreciation contribution net of the permanent differences:
You can use the net taxable (deductible) amount in your tax liability calculations for each projection year in your financial statement.
See Also
Determining Deferred Income Tax Liability
Projecting Depreciation Expense
Depreciation Projection Report
