Short Answer
Identify each temporary difference between the book and tax bases of assets and liabilities, apply the enacted tax rate expected to be in effect when the difference reverses, and assess whether any valuation allowance or other adjustment is needed. Document the assumptions and reconcile the result with the tax compliance team's records.
Comprehensive Answer
The short answer outlines the sequence, but the real difficulty is in execution. Each step involves judgment calls, and errors tend to concentrate in a few predictable places. This article walks through how to carry out the measurement in practice, where it commonly goes wrong, and which edge cases deserve special attention.
Building the Temporary Difference Schedule
Start with a schedule that lists every asset and liability with a book carrying amount and a tax basis. For each line, compute the difference and classify it. A difference that will produce taxable amounts when the asset is recovered or the liability settled creates a deferred tax liability. A difference that will produce deductible amounts creates a deferred tax asset. Measuring the liability well depends on getting this classification right before any rates are applied.
Common sources of taxable temporary differences include:
- Accelerated tax depreciation compared with straight-line book depreciation
- Revenue recognized for book purposes before it is taxable
- Intangible assets acquired in a business combination with little or no tax basis
- Prepaid expenses deducted for tax when paid but capitalized for book
- Unremitted earnings of certain subsidiaries, depending on the company's intent and the applicable accounting guidance
Items That Are Not Temporary Differences
Permanent differences, such as certain non-deductible expenses or tax-exempt income, never reverse and therefore do not create deferred taxes. Misclassifying a permanent item as temporary is a frequent source of overstated balances. When in doubt, ask whether the difference will eventually reverse and generate a tax consequence in a future period.
Selecting the Right Rate
The measurement uses the enacted rate expected to apply in the period the difference reverses. That requires a few practical decisions:
- Determine each jurisdiction in which the difference will reverse, since federal, state, and foreign rates differ.
- Combine federal and state rates on a net basis, recognizing that state taxes are often deductible for federal purposes.
- Schedule the expected reversal pattern when rates are graduated or when enacted rate changes take effect at different times.
- Use only enacted law. Proposed or anticipated changes are not reflected until they are enacted.
When a rate change is enacted, the entire deferred balance must be remeasured, with the effect generally recognized in income from continuing operations in the period of enactment. Preparers should build their schedules so that rates can be updated in one place rather than line by line.
Scheduling Reversals When Rates or Regimes Vary
For many companies a single blended rate is a reasonable approximation. It becomes inadequate when the entity operates in several jurisdictions, when different attributes are subject to different rates, or when tax law limits the use of certain losses or credits. In those cases, a reversal schedule by period and jurisdiction produces a more defensible number. Document why a simplified approach is acceptable if you choose one.
Considering Offsetting Attributes and Allowances
A valuation allowance applies to deferred tax assets, not liabilities. Still, it affects the net picture. Existing taxable temporary differences can serve as a source of future taxable income that supports realizing deferred tax assets, so the timing of liability reversals matters. A liability expected to reverse in the same period and jurisdiction as a deductible difference may support recognizing the related asset.
Also consider uncertain tax positions. If a position that created a temporary difference is not expected to be sustained, the deferred and current tax effects need to be evaluated together rather than separately.
Edge Cases Worth Planning For
Business Combinations
When assets are acquired with a book value above tax basis, a deferred liability generally arises and adjusts the amount of goodwill recognized. Preparers should confirm that the purchase accounting and the tax analysis use consistent fair values.
Indefinite-Lived Assets
Certain assets are not amortized for book purposes but may be amortized for tax. This can create a difference that does not have a clear reversal date. It should be analyzed carefully, since it may not be available as a source of income to support other deferred tax assets.
Items Recorded Outside of Income
When a transaction is recorded in other comprehensive income or directly in equity, the related deferred tax is generally recorded in the same place. Mismatches here create confusing period-to-period effects.
Documentation and Reconciliation
Strong documentation lets a reviewer reproduce the balance without asking the preparer. Retain the temporary difference schedule, the rate derivation, the reversal assumptions, and the reasoning behind any judgment. Then reconcile the ending deferred balance to the tax provision workpapers and to the tax return process, investigating any differences between the estimated basis used in the provision and the basis ultimately reported.
A deferred tax balance is only as reliable as the basis information beneath it. Reconciliation to compliance records is the control that exposes weak inputs.
Finally, roll the balance forward each period, separating the effects of new differences, reversals, rate changes, and acquisitions. A clear rollforward makes review faster and surfaces unusual movements early.