Welcome back. In this lesson, we'll talk about temporary differences and provide a couple of examples of the kind of very simplified examples of how those work. Temporary difference is a difference between the tax bases of an asset liability and it's GAAP basis, the reported amount in the financial statements. The difference may be a taxable temporary difference or deductible temporary difference. Notice that we're talking about the tax basis of an asset and a GAAP basis of a liability. This is sometimes referred to as the asset liability approach or the balance sheet approach. That's the foundation really of a deferred tax accounting. It used to be an income statement approach in the prior standard to this and that's where we get some of this different language that we still see crop up. That's where timing differences and permanent differences come up. The correct terminology today is a temporary difference though, for based upon a difference between a tax basis and a GAAP basis of the asset. The future impact. The taxable temporary differences are taxable in a future period. Taxable temporary differences creates a deferred tax liability, whereas a deductible temporary differences is deductible in a future period, and therefore, creates a deferred tax asset. So, here's a table that sort of shows the FASB terminology of taxable temporary. For revenues, you can have installment sales, that would be taxable temporary. You may be taxing them. You may be recognizing them currently for GAAP purposes, but deferring them for IRS purposes. Performance obligations satisfied over time maybe taxable currently for GAAP purposes and in future periods, for IRS purposes, depending on your revenue recognition policy. Then, also, unrealized holding gains on financial instruments, which would be recognizable for GAAP purposes; but it won't be recognized until the instrument is sold typically for tax purposes. Those would create a deferred tax liability. On the expense side, accelerated depreciation and prepaid expenses could create a deferred tax liability in the future period. Because I'm taking a deduction on my tax return today, then I'm only going to take on the GAAP's financial statements in the future. Deductible temporary amounts, net contract liabilities from advance payments. This was previously referred to as advances from customers or customer deposits. Now, under the new revenue recognition standard, we're referring to those as net contract liabilities because the customer has performed by giving you the cash, and you have yet to perform by delivering the goods or services, and the same thing with advanced rental payments from a customer. Those will be deductible in future periods because you have recognized them already on the tax return, but you haven't recognized them yet for GAAP. And then, estimated expense losses like warranties and credit losses. They're realized for tax purposes when you actually incur the expenses. But for GAAP, you estimate the amounts ahead of time. And the same with unrealized holding losses and these will all create deferred tax assets. Let's look at an example of a deferred tax liability. Your prepaid expenses may be deductible for taxes, but not for GAAP purposes because I've already incurred the cash expenditure, I may be able to deduct them for tax purposes. For GAAP purposes, I'm going to wait and expense them in the period in which they belong. For GAAP, which that's why there are prepaid, they'll be recognized as an expense in a future period. When I account for the prepaid expenses and the cash, I will have a tax. Tax is payable, will be reduced by $200 because I'm deducting them for tax purposes. I'm going to create a deferred tax liability because I'm not deducting them for GAAP purposes from net income. Flash-forward to the next period, when the prepaid assets are recovered, which is good deferred tax terminology. I'm going to have expenses for GAAP purposes, but I won't have an expense for tax purposes. I've already recognized them in the previous period. So now, that deferred tax liability will be reversed, and I recognized a tax benefit on my GAAP financial statements. Not a deduction on the taxable financial statements that all already happened, but I am recognizing that deduction from my tax expense for GAAP purposes in year two, reducing the tax expense. Another way to view the journal entry, suppose the GAAP earnings are $100,000 and the prepaid expenses are the only temporary differences. Not a realistic situation but suppose it was. Well, I would show the tax expense at $20,000, and the taxes payable at $19,800 because I've deferred tax liability of $200, that's occurred. You'll sometimes see the journal entry performed this way. Again, this is that relationship we talked about in the first lesson where tax expense equals the taxes payable plus or minus deferred tax expense and there's my deferred tax liability right now that's creating that amount. Now, in year two, the total GAAP earnings are turned $200,000, and the prepaid expenses are the only temporary difference. So again, I've got my 20 percent tax rate. My tax expense is $40,000, my deferred taxes liability is $200. I'm actually paying taxes payable of $40,200. Now, notice at that $200 just got shifted from one year to another for GAAP purposes. Let's take a look at a deferred tax asset example. Now, we have advance payments from customers that create a taxable net contract liability that is recognized under GAAP revenue in future periods when the liability is settled. I'm not recognizing revenue yet under GAAP, but I would be for tax purposes. I receive the cash of $2,000, and I have a contract liability of 20 percent tax rate. I'm going to have a deferred tax asset of $400 and a deferred tax benefit of $400 and this is a deductible temporary difference. In a subsequent period, when the contract liability is settled and GAAP revenue is recognized, I'm going to recognize, reverse the contract liability and recognize revenue. Now, I will have tax expense for GAAP purposes and reverse the deferred tax asset so the tax expense is recognized in year two. Both of these example features amounts that are included in taxable income in the current period with the GAAP impact in a future period. Either prepaid, previously deducted, and recognized as an expense, or an advance payment previously taxed, and then, recognized as revenue in a subsequent period. Notice that a deferred tax asset or a deferred tax liability, it's not the same as a tax refund receivable or a taxes payable. They're different concepts. A tax refund receivable is a cash item that's going to come back as in the form of a check or a credit for your future taxes from the taxing authority. A tax liability, you need to write a check for that to the taxing authority. That's not what a deferred tax item or a deferred tax liability is. It's not necessarily a cash flow associated with that directly. There are going to be consequences in the future for your tax expense and your tax liability, but it's not the same as a taxes payable or taxes receivable and don't confuse the two. They do represent amounts of reconcile differences between GAAP income and taxable income in future periods. You don't discount those future expected settlements, and realizations of deferred tax liabilities and assets. Why not? Well, you don't discount it because that would require an extraordinary amount of bookkeeping and assumption making that probably would exceed any benefit that you would get from preparing that calculation. Again, as we talked about in the beginning lesson, these amounts are really complicated. Looking to the future is always a complicated amounts of the decision was made, not to discount these items, and also, not to recognize them at fair value. Keep in mind what the deferred tax asset or deferred tax liability represents in that regard. Because, again, in real life, there may be many different items as future deductibility offsets. Here's an example of a what that could look like. This is a real life example of the disclosure in a set of financial statements of the deferred tax assets and liabilities. As you can see, there can be a large number of different items. Some of which go one way and some of them which go the other. That can result in a net deferred tax. In this case of $6,165,000. You can see that there's items related to intangible assets which are deductible differently for tax and for GAAP. Under GAAP, you would only deduct them when they're impaired often, especially goodwill. Inventory-related items, accelerated depreciation, you can see as a very large item in here, unremmited foreign earnings, pensions and OPEBs. There can be a big difference between when their deductible, and when they're payable, or when we expense them on the financial statements. Compensation-related is often related to stock options. The total temporary differences here are shown that there's a $7.5 million liability and a 1.3 million dollar asset, and we net them, in this case, to total deferred of 1.6. So far, we've covered steps one to three, where we identify the total temporary differences. We measure the deferred tax liabilities, and we measure the deferred tax assets from temporary differences. Now, we proceed onto discuss the rest of the accounting for the deferred tax items in the subsequent lessons. Thank you very much.
