40 50 of year 2 ppe carrying 30 12 4 40 10 30 x 40 12

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(40) (50) - of Year 2: PPE carrying value ... 40 10 $30 $12 $ 4 - ($40 - $10) ($30 x 40%) ($12 - $8) =aT 3: Depreciation ..... , ... , .... (40) (10) - of Year 3: PPE carrying value ... 0 0 $ 0 $ 0 $(12) - ($0 - $0) ($0 - $12) third column in Exhibit SkI shows the "book-tax" difference, which is the difference between GAAP net value and the tax basis at the end of each year. The fourth column shows the deferred tax liability at the end -e:a h period, computed as the book-tax differences times the tax rate. We see from the fourth column that when financial reporting net book value is greater than the tax basis, the company has a deferred tax liability on its
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5-37 Module 5 I Revenue Recognition and Operating Income balance sheet (as in Years 1 and 2). Companies' footnotes provide information about deferred taxes. For example. Pfizer's footnote reports a deferred tax liability (net) of $1,726 for its property, plant and equipment, which indi- cates that tax basis for PPE is less than GAAP net book value, on average, for Pfizer's PPE. Accounting standards require a company to first compute the taxes it owes (per its tax return), then to compute any changes in deferred tax liabilities and assets, and finally to compute tax expense reported in the income state- ment (as a residual amount). Thus, tax expense is not computed as pretax income multiplied by the company's tax rate as we might initially expect. Instead, tax expense is computed as follows: Tax Expense = Taxes Paid - Increase (or + Decrease) in Deferred Tax Assets + Increase (or - Decrease) in Deferred Liabilities The far-right column in Exhibit 5A.J shows the deferred tax expense per year, which is the amount added to. or subtracted from, taxes paid, to arrive at tax expense. If we assume this company had $100 of pre-depreciation income, its taxable income and tax expense (assuming a 40% rate) follows: Taxes Paid Deferred Tax Expense Total Tax Expense Year 1 .......... ............ $16 ($100 - $60) x 40% $20 ($100 - $50) x 40% $36 ($100 - $10) x 40% $24 $24 $ 8 $ 4 $24 Year 2 . $(12) Year 3 . In this example, the timing difference between the financial reporting and tax reporting derives from PPE and creates a deferred tax liability. Other differences between the two sets of books create other types of deferred tax accounts. Exhibit 5A.2 shows the relation between the financial reporting and tax reporting net book values, am! the resulting deferred taxes (liability or asset) on the balance sheet. Sources of Deferred Tax Assets and Liabilities For Assets ... Financial reporting net book value > Tax reporting net book value ---+ Deferred tax liability on balance sheet Financial reporting net book value < Tax reporting net book value ---+ Deferred tax asset on balance sheet For Liabilities ... Financial reporting net book value < Tax reporting net book value ---+ Deferred tax liability on balance sheet Financial reporting net book value > Tax reporting net book value ---+ Deferred tax asset on balance sheet A common deferred tax asset relates to accrued restructuring costs (a liability for financial reporting purposes ,_ Restructuring costs are not deductible for tax purposes until paid in the future and, thus, there is no accrual restruc- turing liability for tax reporting, which means it has a tax basis of $0. To explain how this timing difference
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