A variety of situations can create differences in timing between the
financial reporting of revenues and expenses and the tax reporting of
the same items. These circumstances could create the situation you
are describing where taxes are owed even though the company does not
show a pretax book profit for the year.
The most common reason for this kind of situation is differences
between the depreciation method used for tax purposes and the
depreciation method used for the books. The straight-line
depreciation method is often used for financial reporting, but the
Accelerated Cost Recovery System (ACRS) is generally used for income
tax reporting. Assets typically have shorter lives under ACRS than
they have for financial reporting purposes, and ACRS ignores salvage
value. Any salvage value can create a taxable gain upon retirement of
the asset.
Other factors can also create a timing difference between the tax
return and books. Installment sales, long-term construction projects,
expenses for uncollectible amounts, and warranty expenses are
examples. Expenses from uncollectible amounts and warranty expenses
can both result in financial statement income being less than taxable
income.
If the company in question does not have assets that are depreciating,
expenses from uncollectible amounts, or warranty expenses, then you
would have a good reason to be concerned. However, most companies
have at least one of these categories, and most have at least two.
Therefore, the accountant's explanation that deferred taxes have
created this situation is likely to be reasonable absent additional
information regarding the company's operations. There should be a
Deferred Income Tax Liability account on the balance sheet showing the
difference between the income tax expense reported on the financial
statements and the income taxes payable computed on the tax return.
This should have been credited when taxes payable were less than the
income tax expense reported in the firm's financials and should be
debited when the cash payment exceeds the reported expense.
Sincerely,
Wonko
Source: "Financial Accounting" sixth edition by Stickney, Weil, and
Davidson, Harcourt Brace Rabinovich Inc. (1991) pages 333, and
437-443. |
Request for Answer Clarification by
dongud-ga
on
01 Apr 2005 21:34 PST
Based upon this, would you agree that, when there are not warranty,
depreciation, installment sales, bad debt, or contingency items, a
GAAP financial statement showing a profit-before-tax loss should not
be showing a tax expense?
For the company in question, the only known issue is in regards to
book to tax differences in depreciation, but these are minimal
compared to the tax involved.
With these additional facts, should I weigh your comment about having
"good reason to be concerned" more seriously?
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Clarification of Answer by
wonko-ga
on
03 Apr 2005 21:56 PDT
I merely listed the most common reasons for a tax expense to be
incurred without an actual cash flow at that time. There are many
other possible circumstances that could create one. However, if it is
not one of the obvious reasons, then it is worth looking into. First,
there should be corresponding entries on the balance sheet and
statement of cash flows to reflect the creation of a liability and the
absence of a cash payment. Furthermore, if possible, I would want to
look at the deferred tax calculations to ensure this is being done
legitimately. Another question to consider is what the firm or
individuals associated with the firm receive an advantage from
understating its profit after taxes to you.
The explanation is most likely legitimate in that there are certainly
a myriad number of ways such a circumstance could occur. However,
there is no harm at least making sure the other basic accounting
matches the income statement and, if possible, reviewing the firm's
tax forms.
A further note on depreciation and research and development expenses:
Congress has allowed extremely aggressive depreciation for tax
purposes for investments that has magnified its effect. Research and
development expenses can also be deducted immediately. Significant
research and development expenses that have been capitalized could
also account for the circumstance you describe.
Sincerely,
Wonko
"The Coming Tax Height" by Don Durfee, CFO Magazine (April 1, 2005)
http://www.cfo.com/article.cfm/3804671/2/c_3805512?f=archives
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