Accounting for Income Taxes
What is a deferred tax asset or liability? How do I calculate my effective tax rate? These are questions you may be asking after significant business growth, a new lender or investor, or some other catalyst requiring more sophisticated financial statements. If your company is a C corporation issuing audited or reviewed financial statements under U.S. GAAP, accounting for income taxes under ASC 740 is part of the package. Pass-through entities like S corporations and partnerships generally don’t carry these accounts, though there are exceptions. The truth is, these calculations are complex and fall outside the day-to-day work of most tax practices. I’ve heard other ASC 740 practitioners describe it as an extraordinary amount of work for a single journal entry, which is actually quite accurate. This is not something you want to find out about from your auditor.
So back to the original questions: what is a deferred tax asset or liability? The most basic explanation is that some items are recognized at different times for book and tax purposes. When that timing difference reverses, you will either pay tax now and realize a benefit later (a deferred tax asset), or realize the benefit now and pay tax later (a deferred tax liability). The most common example is cost recovery, better known as depreciation or amortization. You may already be familiar with this from your current operations or tax planning; the mechanics are the same, but the financial statement reporting is more in depth. Other common differences include accrued compensation, inventory capitalization, and reserves. Net operating losses and credit carryforwards can also create deferred tax assets, which then have to be evaluated for whether you’ll actually be able to use them.
What about the effective tax rate? This is your total income tax expense, both current and deferred, as a percentage of your pre-tax book income. While the federal corporate rate is 21%, several items can push it up or down: state taxes, permanent differences such as nondeductible expenses or tax-exempt income, foreign income taxed at a different rate, and tax credits. Interestingly, timing differences like depreciation generally don’t change the effective rate; they just shift tax between the current year and future years.
If this is a wall your business is running into, find a door, or in this case an expert with years of experience in the field. Scioto CPAs & Associates is open to new clients in need of this service and is structured to help smaller businesses overcome the administrative burden. Contact me today so you can breathe easier tomorrow.
