Deferred Tax Accounting in 15 Minutes: ASC 740 Assets, Liabilities and Valuation Allowance (FAR Notes)

Companies keep two sets of books for income: GAAP financial statements and the tax return. The two rarely agree in any given year, because tax law and GAAP recognize the same events at different times. Deferred tax accounting under ASC 740 is the bridge between them: it records today the tax consequences of events that will hit the tax return tomorrow. FAR tests this relentlessly because every piece follows one logic. Learn the logic once and the journal entries, the valuation allowance, and the rate-change questions all solve themselves.

Deferred tax accounting: the core idea

Start with the only distinction that matters. A TEMPORARY difference reverses over time: an event hits book income and taxable income in different periods, so total lifetime income is the same. A PERMANENT difference never reverses: it affects one set of books and never the other. Only temporary differences create deferred taxes. Permanent differences (tax-exempt interest, fines, 50% of meals) affect the effective tax rate but create no deferred tax asset or liability, ever. That single rule eliminates half the wrong answers on this topic.

Temporary differences: DTA vs DTL

A temporary difference produces a deferred tax asset (DTA) when it will give a FUTURE TAX DEDUCTION, and a deferred tax liability (DTL) when it will create FUTURE TAXABLE INCOME. The formulas: DTA = future deductible amount x enacted tax rate; DTL = future taxable amount x enacted tax rate. Always use the ENACTED rate, the rate already signed into law for the future year, not a proposed or expected rate.

Situation	Book vs Tax	Temporary difference	Result
Warranty liability recorded now, deducted when paid	Book expense now, tax later	Future deductible	DTA
Unearned revenue taxed now, earned later	Tax income now, book later	Future deductible	DTA
Accelerated (MACRS) depreciation	Tax depreciation faster	Future taxable (book will exceed tax deductions later)	DTL
Installment sale: book sale now, tax as collected	Book income now, tax later	Future taxable	DTL
Allowance for doubtful accounts	Book expense now, tax when written off	Future deductible	DTA

As a memory hook, liabilities on the book balance sheet (warranties, unearned revenue) usually mean DTAs, because settling them gives future deductions. Assets written down faster for tax (PPE under MACRS) usually mean DTLs.

Deferred tax accounting: worked example (DTA and DTL)

A company has a $100,000 warranty liability on its books (tax basis zero, since no deduction until paid) and equipment with book value $500,000 versus tax basis $400,000 (accelerated depreciation). Enacted rate: 21%.

Warranty: future deductible amount = $100,000 – $0 = $100,000. DTA = $100,000 x 21% = $21,000. Journal: Dr Deferred tax asset $21,000, Cr Income tax benefit (deferred) $21,000.

Equipment: future taxable amount = $500,000 – $400,000 = $100,000. DTL = $100,000 x 21% = $21,000. Journal: Dr Income tax expense (deferred) $21,000, Cr Deferred tax liability $21,000.

On the balance sheet, ASC 740 requires ALL deferred taxes to be classified as NONCURRENT, and DTAs and DTLs are netted by tax jurisdiction (federal with federal, state with state). There is no current deferred tax line anymore.

The valuation allowance

A DTA is only worth what the company will actually realize. ASC 740 applies the “more likely than not” test (greater than 50% probability): if it is more likely than not that some portion of the DTA will NOT be realized, the company records a valuation allowance, a contra-asset that reduces the DTA. The allowance runs through income tax expense, so it hits the bottom line immediately.

Realizability is judged on four sources of future taxable income:

1. future reversals of existing taxable temporary differences (existing DTLs),
2. future taxable income apart from reversals,
3. taxable income in carryback years, and
4. tax planning strategies that would create taxable income.

Negative evidence, especially a history of cumulative losses in recent years, is given heavy weight and is very hard to overcome. A three-year cumulative loss is the classic exam trigger for requiring a valuation allowance.

Worked mini-example: a company has a $50,000 DTA but, after weighing a three-year cumulative loss against projected profits, concludes only $30,000 is more likely than not realizable. Valuation allowance = $20,000. Entry: Dr Income tax expense $20,000, Cr Valuation allowance (contra-DTA) $20,000. If fortunes later improve, the allowance is reversed through the same expense line.

Rate changes and intraperiod allocation

When Congress changes the rate, deferred taxes are remeasured at the newly ENACTED rate in the period of enactment (when the President signs, not when effective), and the entire catch-up adjustment flows through continuing operations, even if the DTA/DTL originally related to something else. For example, a $100,000 DTL at 21% becomes $100,000 x 25% = $25,000 when the rate rises to 25%; the $4,000 increase is debited to income tax expense from continuing operations.

Intraperiod tax allocation then spreads total tax expense across where the income appeared: continuing operations gets the residual, while discontinued operations, other comprehensive income, and prior-period adjustments each get the tax effect of their own items. The exam favorite: a gain in OCI with a loss from continuing operations still allocates tax expense to OCI and a benefit to continuing operations.

Deferred tax accounting: exam traps that fail candidates

1. Permanent differences never create deferred taxes. Tax-exempt interest and fines affect the rate reconciliation only.
2. Enacted, not effective. Always measure with the enacted future rate; a proposed rate change is ignored until signed.
3. Valuation allowance is a contra-ASSET against DTAs only. It never applies to DTLs, and cumulative losses make it nearly mandatory.
4. All deferred taxes are noncurrent and netted by jurisdiction. There is no current DTA/DTL classification.
5. Rate-change catch-ups hit continuing operations. The whole remeasurement goes through continuing ops in the enactment period.
6. DTA vs DTL direction. Future deduction = DTA; future taxable = DTL. When in doubt, ask: “will this reduce a future tax bill?”
7. Uncertain tax positions (FIN 48/ASC 740-10): recognize only if more likely than not to be sustained on audit; measure the LARGEST amount with greater than 50% cumulative probability.
8. Intraperiod allocation order. Compute total tax first, then allocate to discontinued operations, OCI, and other special items; continuing operations gets what is left.

One-Page Revision: ASC 740

• Temporary differences reverse and create deferred taxes; permanent differences never do.
• Future deductible = DTA; future taxable = DTL. Measure at the ENACTED tax rate.
• Common DTAs: warranty liabilities, allowance for doubtful accounts, unearned revenue, NOL carryforwards.
• Common DTLs: accelerated depreciation (MACRS vs book), installment sales.
• Valuation allowance: required when realization is not more likely than not; contra-asset to DTA through tax expense; cumulative losses are heavy negative evidence.
• Four realizability sources: reversal of DTLs, future taxable income, carryback income, tax planning strategies.
• All deferred taxes noncurrent; net DTA/DTL by tax jurisdiction.
• Rate changes: remeasure at enactment, full catch-up through continuing operations.
• Intraperiod allocation: special items (discontinued ops, OCI) get their own tax; continuing operations is the residual.
• Uncertain tax positions: recognize if more likely than not; measure at the largest amount above 50% cumulative probability.
• For the authoritative text, see the FASB Accounting Standards Codification; for more FAR coverage, see our FAR lease accounting notes.

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