How to Account for Deferred Taxes

A business needs to account for deferred taxes when there is a net change in its deferred tax liabilities and assets during a reporting period. A deferred tax is usually the difference between the carrying amount of an asset or liability and its corresponding tax basis, multiplied by the applicable income tax rate. The amount of deferred taxes is compiled for each tax-paying component of a business that provides a consolidated tax return. To account for deferred taxes requires completion of the following steps:

Identify the existing temporary differences and carryforwards.
Determine the deferred tax liability amount for those temporary differences that are taxable, using the applicable tax rate.
Determine the deferred tax asset amount for those temporary differences that are deductible, as well as any operating loss carryforwards, using the applicable tax rate.
Determine the deferred tax asset amount for any carryforwards involving tax credits.
Create a valuation allowance for the deferred tax assets if there is a more than 50% probability that the company will not realize some portion of these assets. Any changes to this allowance are to be recorded within income from continuing operations on the income statement. The need for a valuation allowance is especially likely if a business has a history of letting various carryforwards expire unused, or it expects to incur losses in the next few years.

A valuation allowance may not be needed when there is positive evidence to support a deferred tax asset. For example:

The company has a large sales backlog and sufficient production capacity to ensure that it can produce a sufficient amount of taxable income.
The company has a sufficiently large amount of appreciated asset value to generate taxable income.
The company has a strong track record of profitability, along with evidence indicating that the loss triggering the deferred tax asset is likely to be an aberration.