Deferred Income Taxes

Deferred income tax liabilities and assets represent future income tax obli- gations or future income tax benefits as a result of past events. They arise when GAAP and the Code conflict with regard to the timing of revenues, expenses, gains, and losses. The resulting timing differences are temporary (in most cases), but nonetheless create a reporting difference between tax- able income and financial income. Timing differences result when revenues, gains, expenses, or losses affect financial reported income in one period but taxable income in another period.

As an example, let’s assume The Home Depot depreciates a $50,000 asset over 5 years for financial reporting purposes but uses a 3-year acceler- ated cost recovery schedule for tax purposes. Table 3.3 illustrates deprecia- tion expense timing differences.

As noted, depreciation expense in year 1 is $25,000 for tax purposes and $10,000 for financial reporting purposes. The $15,000 difference is called an originating temporary difference. When we move to year 2, another $5,000 originating temporary difference results. The combination of the two differ- entials then becomes a future reversing difference. While no reversals occur in year 3, years 4 and 5 show a combined total of $20,000 reversing differ- ences. What this means is that The Home Depot would report a deferred income tax liability in anticipation of greater taxable income down the road when compared to financial reported income. Keep in mind that while depreciation expense differences exist within periods, they are equal in amount over the life of the asset. In either reporting, $50,000 of depreciation expense is recognized. This is why these originating differences are noted as temporary differences.

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