Deffered Tax and Tax Expense and Owners Equity Cheat Sheet

1) Deffered Tax Accruals:

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How then should we record the tax expense? In particular, what should we do to reflect the effect of
differences in accounting methods used in the firm's financial reporting and tax books?

Standard setters have dealt with these accounting differences by requiring that the tax expense be
based on Income Before Taxes in the financial reporting books rather than Taxable Income in the tax
books. This leads to the creation of a deferred tax accrual to reflect the tax effect of any accounting
method differences that exist between the two sets of books. As you will learn, the accounting effect
of most of these accounting differences reverse in some future period. Consequently, accountants
refer to these accounting differences as "temporary accounting differences".

The deferred tax accrual is consistent with the matching concept since it matches the tax expense in
each year with Income Before Taxes in the financial reporting books. The tax accrual can appear as a
liability or an asset on the firm's balance sheet.

2) Deffered Tax Accruals: Timing Differences

Deferred tax accounting is used when the following three conditions hold:

A transaction or event is accounted for differently in an entity's financial reports and income tax returns.
The accounting effect of the difference in accounting policies is temporary in that the early period effects
of the difference are reversed in later periods.
The accounting difference has tax consequences.

When these conditions hold there is a difference in the timing of financial reporting and taxable income.
Let's return to the example of Pascoe Inc., which used accelerated depreciation for its tax books and straight-line
depreciation for its financial reporting books. We can see that the depreciation difference meets all three of the
above conditions required for using deferred tax accounting.

The accelerated depreciation method leads to higher depreciation charges than the straight-line method in
the early years of an asset's life, resulting in a lower taxable income in those years.

The effect is temporary since at some point in the asset's depreciable life the accounting effect of the two
depreciation methods reverses. This occurs in the later years of the asset's depreciable life when financial
reporting straight-line depreciation charges are higher than the tax return accelerated depreciation
charges.
The difference in the use of the two depreciation methods has tax consequences. The higher early year
tax deductions for depreciation lead to lower taxable income than if the company used straight-line
depreciation for tax return purposes. In the later years of the asset's depreciable life this situation is
reversed.

3) Deffered Tax Accruals: Permanent Differences

- Not all differences between financial and tax return accounting result in the recognition of a deferred tax
accrual. These exceptions occur when there is a permanent rather than a temporary difference between
a company's financial and tax accounting. Permanent differences occur when either revenue or
expenses are recognized for tax return purposes but never for financial reporting purposes or expenses
or revenues are recognized for financial reporting purposes but never for tax return purposes. In other
words, permanent differences are accounting differences that do not reverse in future periods.

4) Deffered Tax Liabilities:

- A deferred tax liability is the future tax consequences attributable to temporary accounting differences
between financial and tax accounting policies where the future tax consequences result in higher future
taxes.

5) Deffered Tax Assets:

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Deferred tax assets are the opposite of deferred tax liabilities. Deferred tax assets arise when
temporary differences between a company's financial and tax accounting result in future lower taxes.

Deferred tax assets and their related deferred tax benefits are only recognized in the balance sheet
and income statement if management believes it is "more likely than not" (a better than 50-50
chance) that the future tax benefit will be used to lower the tax payments in subsequent years. This
last condition conforms to the conservative concept.

6) Deffered Tax Assets: Loss Carryforward

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Deferred tax assets can arise also if there are no temporary differences in reporting methods used for
tax and financial reporting books, but the firm reports losses for tax purposes.

Under the US tax code, companies that report losses on their tax returns can carry forward these
losses for tax return purposes for 20 years and apply them as an offset to any future taxable income.
If the current loss is expected to result in lower future tax payments, the tax equivalent of the loss is
recorded as a deferred tax asset and a deferred tax benefit as recognized in the income statement.
The amount of the past losses carried forward to offset future taxable income is called a "tax loss
carryforward."

The US tax code also provides for "tax loss carrybacks." This provision of the codes permits
companies to use their current tax return losses to offset taxable income reported in prior periods.
This may result in a refund of prior period tax payments.

7) Current and Deffered Tax Expense:

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The tax expense in a firm's income statement can be divided into two components, the current
portion and the deferred portion.

The current portion is the tax due to the tax authority that period.

The deferred portion is the tax accrual required to reflect any temporary accounting differences
between financial and tax accounting policies.

For example, recall that for Pascoe, which had a difference in taxable and financial reporting as a
result of differences in depreciation methods, the full tax expense in year 1 was $600. Of this, $400 is
taxes due, and is called the current tax expense. The other $200 is the deferred tax expense and
reflects the tax effect of the difference in accelerated and straight-line depreciation used in the tax
and financial reporting books.

Owners Equity Concepts

1) Common Stock:

2)

When a company issues common stock, it frequently identifies a nominal value of the stock as its par
value. Assigning a par value to a stock is a historical practice that today has little practical
significance. By law each stock certificate has a dollar value printed on its face. This amount is its par
or stated value. Par value does not indicate a stock's worth, but it does have a legal significance. If a
shareholder buys stock directly from the issuing company and pays less than the par value, the
shareholder could be liable to pay the difference if called upon by the company's creditors. Today, this
could not happen. Most states prohibit the issuance of common stock at less than its par value or the
par value is set at a nominal amount well below the issuance price.

For stock that has a par value, the balance sheet shows the value of the stock at its par value. Of
course, the stock is rarely issued at par value. Usually it is issued at a much higher amount. The
difference between the issue amount and the par value is called Additional Paid-in Capital. It also
appears on the balance sheet in the owners' equity section.

The sum of the par value and additional paid-in capital for common stock is called Paid-in Capital.

Preferred Stock:

Common stock is the most popular form of equity investment you will encounter. But some companies also issue
other classes of stock, notably preferred stock. There are several important differences between preferred stock
and common stock.

Preferred stock is less risky than common stock since it has higher priority in receiving dividend payments
and return of capital in the event of a liquidation of the company.
Preferred stock does not have voting rights.
Preferred stock is typically entitled to a fixed dividend rate, comparable to fixed interest debt. In contrast,
common stock is not entitled to any specified dividend payment.

There are many different types of preferred stock:

3)

4)

Cumulative Preferred Stock: specifies that if the company is unable to pay the preferred dividends
in a given year, it cannot pay any common stock dividends until the preferred dividends in arrears are
fully paid.

Convertible Preferred Stock: specifies that the preferred stock can be converted into common stock
at a defined exchange rate at the option of the preferred stock owner.

Redeemable Preferred Shares: specify that the issuing company must buy back the preferred
shares at a defined price within a defined time period

Stock Repurchases
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Sometimes companies buy back their own common stock. This purchased stock is called treasury
stock.

Stock repurchases are very similar to dividends, in that they result in cash being distributed to
shareholders.

However, whereas dividends are typically taxed at ordinary income rates, stock repurchases enable
some investors to receive cash in a form that leads to a capital gain, which is typically taxed at capital
gains rate that is lower than the rate used to tax ordinary income. This tax difference has led many
companies to make distributions to shareholders in the form of a stock repurchase rather than a
dividend.

Dividends

Firms can decide to pay out cash to shareholders in the form of a dividend. Typically, firms avoid paying
dividends if they are growing and can reinvest cash generated from operating the business profitably in new
equipment or to support working capital needs.
However, mature firms that produce more cash from operations than they need for funding future growth may
decide to pay out excess cash to shareholders in the form of a dividend.

The stocks of firms that pay dividends are called income stocks, and tend to attract a different class of investor
than those that avoid dividends to focus on growth. Investors attracted to income stocks include:

Retired investors who want a steady stream of income, and

Institutions that do not pay taxes on dividends.

5)

Stock split
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Companies sometimes split their stock by increasing the number of shares outstanding. A split
changes the number of shares owned by its current shareholders, but does not change the book
values of the firm's assets, liabilities, or its owners' equity.

For example, consider Pilot Inc. that has 10,000 shares outstanding and a stock price of $5, implying
that its market capitalization is $50,000 (10,000*$5). A 2-for-1 stock split would increase the number
of shares outstanding by a factor of 2, to 20,000. But since the split has not changed the firm's
business fundamentals, its market capitalization should not change. For this to happen the stock
price would have to drop by 50% to $2.50. The firm would now have 20,000 shares outstanding and a
stock price of $2.50, and continue to have a market capitalization of $50,000 (20,000*$2.50).

Some argue that stock splits actually lead to higher market capitalizations for the splitting firms
because they signal that management confidence in the firm's future prospects, or by making it less
costly for small investors to own small parcels of shares.