FAS 109: a primer for non-accountants.

Introduction

Income tax provisions and Schedule M-1(1) of Form 1120 (Corporation Income Tax Return) bridge the financial accounting world and the Internal Revenue Code. The benefit of understanding an income tax provision and an M-1 is that a preparer can bridge the gap between these two worlds.

This will in turn allow the preparer to talk intelligently with auditors, controllers, chief financial officers, corporate tax consultants, and tax return preparers. Because many controllers and CFOs do not have a tax background, it is important to learn at least the fundamentals of accounting for income taxes for financial accounting purposes.

This article does not discuss every situation that may arise on an income tax provision. What follows is intended to cover the purpose of a provision and the components of a provision, including deferred tax assets and liabilities as well as effective tax rate. The article concludes with an income tax provision template with the formulas footnoted.

Purpose of an Income Tax Provision

The Financial Accounting Standards Board issued "Statement 109: Accounting for Income Taxes" (FAS 109) in February 1992. The purpose of FAS 109 is to recognize (a) the amount of taxes payable or refundable for the current year and (b) the deferred tax liabilities and assets for the future tax consequences of events that have been recognized in a corporation's financial statements or tax returns. In essence, FAS 109 requires public companies to disclose a reconciliation of the reported amount of income tax expense to the amount of income tax expense that would result from applying domestic federal statutory rates to pretax financial income.

Deferred Tax Assets/Liabilities: How Do They Work?

Technically, deferred tax assets/liabilities are timing or temporary differences multiplied by the tax rate, also known as "tax effected." Temporary differences arise where the tax treatment of an item is temporarily different from its financial accounting treatment. For example, for a specific account, GAAP may allow a $20,000 expense and the Internal Revenue Code may allow only an $8,000 tax deduction. In this case, there will be a temporary difference if the Internal Revenue Code allows for the remaining $12,000 to be deducted in subsequent years.

A deferred tax asset/liability is the sum of the temporary differences for the ending balance in that account multiplied by the tax rate. The ending balance is relevant because FAS 109 takes a balance sheet approach. "Balance sheet approach" means that in arriving at a deferred tax asset or liability, the ending balance amount is the relevant number. Therefore, in the example above, if the account had a prior-year ending balance for tax purposes of $30,000 and $65,000 for book purposes and a current-year ending balance of $38,000 for tax purposes and $85,000 for book purposes then the temporary difference would be $47,000.

To further illustrate, assume the above balances are accrued vacation. Thus, at the end of the prior year (i.e., prior-year ending balance) there was a $65,000 accrual of vacation for book purposes. This means that, as of the end of the year, there was $65,000 of vacation expense that was owed to the employees, but the employees had not taken the vacation days by year-end. For tax purposes, the balance was $30,000. The difference in the treatment results from a tax rule that allows a deduction for accrued vacation used within 2-1/2 months after yearend.(2) In the example, the employees took $30,000 of the $65,000 vacation accrual within the requisite time period. Therefore, of the $65,000 vacation for book purposes, $30,000 can be deducted-for tax purposes. As a result, at the end of the prior year, there existed a $35,000 temporary difference. This represents the amount expensed for book purposes but disallowed as a deduction for tax purposes.

At the end of the current year there exists an $85,000 balance in the vacation accrual account. This means that $85,000 worth of vacation days is owed to the company's employees but these days have not been taken. For tax purposes, $38,000 is the deduction. The deferred tax asset would be $47,000 multiplied by the tax rate. Schedule M-1 focuses on the income statement numbers; that is to say, the flux between the prior year's temporary difference and the current year's balance will be the Schedule M-1 entry. This is the current-year activity.

Account               12/31/98   Current-year
                      Balance    Activity

Vacation       Book   65,000     20,000
Accrual        Tax    (30,000)   (8,000)
                      35,000     12,000

Net Deferred
Tax Asset/
 (Liability)

Account        12/31/99  Tax    Deferred Tax
               Balance   Rate   Asset/(Liability)

Vacation       85,000    X %    85,000 x X%
Accrual        (38,000)  X %    (38,000) x X%
               47,000

Net Deferred
Tax Asset/                              X
 (Liability)

1. Tax Rate

The tax rate used in the previous illustration, is the federal statutory rate plus the state tax rate, net of federal benefit. The federal statutory rate is set forth in section 11(b) of Internal Revenue Code. The state tax rate net of federal benefit, however, takes several calculations. First, if the company is only subject to tax in one state, then that income tax rate is used as the starting point. Most public companies, however, are subject to state tax in many states. Therefore, an estimate must be used by looking at total state taxes paid as a percentage of taxable income. For example, if 50 percent of Company X's income comes from New York (9 percent income tax rate) and 50 percent comes from Colorado (4.75 percent income tax rate), then the blended rate will be 6.875 percent. For more complicated provisions, rather than using a blended rate, separate components of the provision are calculated for each state based on projected apportionment factors.

The second step for calculating the state tax rate net of federal benefit is to multiply the inverse of the federal statutory rate by the blended state tax rate. For example, 65 percent (assuming a 35-percent federal statutory rate) x 6.875 percent equals 4.47 percent. Thus, the tax rate used to convert temporary differences into deferred tax assets/liabilities is 39.47 percent (35 percent + 4.47 percent). "Net of federal benefit" means that, because for federal income tax purposes a taxpayer can deduct their state income taxes from gross income, the company is only paying, on a net basis, 65 percent (again assuming a 35-percent federal rate) of the state tax rate because of the state tax deduction. Accordingly, the federal benefit of state taxes is 35 percent of the state income tax rate.

Tax Rate

Federal Rate                         35%
State (Blended Rate)     6.875%
Federal Benefit          (2.4%)
Net of Federal Benefit             4.47%

Total Tax Rate                    39.47%

2. Deferred Tax Assets

A deferred tax asset is a future tax benefit. For example, if a corporation accrues its obligation for unpaid vacation at year-end, for book purposes the amount is expensed or subtracted from book income. As previously stated, however, for tax purposes, any portion of the vacation accrual not paid out within 2-1/2 months from year-end cannot be deducted for tax purposes. For book purposes, it has been "deducted" from book income. It is a deferred tax asset because it will be a tax deduction in the future when it is paid.

The foregoing example above is important because it illustrates that a deferred tax asset is the GAAP method of acounting for a future benefit. In addition to differences in the book and tax recognition of expenses, a deferred tax asset can also arise from differences in recognition of income. For example, if a corporation is a lessor and receives advance rental payments for a building it leases, the tax and book accounting purposes of the payments may differ. The tax laws, under certain circumstances, require the corporation to take into income the entire amount of the payment, even though the payments include monthly payments for the period occurring after the close of the tax year. For book purposes, this income is not included into income until the payment is actually "earned," that is to say, as each month passes. This is also a deferred tax asset because the item causes a greater amount of income in the current period for tax purposes than it does for book purposes. Why? Because in subsequent years, the corporation will recognize book income when there is not a corresponding recognition of taxable income. Thus, where income is recognized in the current year for tax purposes and will be recognized in subsequent years for book purposes, a deferred tax asset arises.

FAS 109 follows a balance-sheet approach, so the deferred tax asset that arises is the tax-effected ending-year balance of the advance rental payment deferral. To further illustrate the point, assume that the amount of the advance payment book deferral was $22,000 as of December 31, 1998, and $10,000 as of December 31, 1999. This means that on December 31, 1998, $22,000 was included in taxable income whereas none was included in book income. Within the next 12 months, $12,000 of the $22,000 was taken out of the advanced rental payment deferral account and added to rent income for book purposes. Thus, the deferral account was reduced by this amount. At the end of 1999, the deferral account stood at $10,000 and the temporary difference was reduced from $22,000 to $10,000. Further, the deferred tax asset was reduced from $8,683 (i.e., the December 31, 1999, temporary difference multiplied by the tax rate) to $3,947.

Account                   12/31/98      Current-year
                          Balance       Activity

Advanced Rental    Book   $     0       $      0
Payment Deferral   Tax    22,000        (12,000)

Net Deferred
Tax Asset/                      8,683
 (Liability)

Account            12/31/99   Tax      Deferred Tax
                   Balance    Rate     Asset/(Liability)

Advanced Rental    $    0     39.47%   $    0
Payment Deferral   10,000     39.47%   $3,947

Net Deferred
Tax Asset/                             $3,947
 (Liability)

3. Deferred Tax Liabilities

Deferred tax liabilities are the reciprocal of deferred tax assets. Journal entries alone, however, do not always reveal whether an entry is a deferred tax asset or liability.

Companies must comply with GAAP and the Internal Revenue Code when determining asset depreciation methods. Usually, the tax depreciation will be greater than the financial accounting depreciation. In the example below, the company is depreciating its assets quicker for tax purposes than for book purposes. Note the December 31, 1998, and December 31, 1999, figures are accumulated depreciation and the current-year activity is the depreciation in the current year. This results in a net temporary difference of $2,300 and a net deferred tax liability of $908 at December 31, 1999.

Account               12/31/98   Current-year
                      Balance    Activity

Depreciation   Book   5,500      2,200
               Tax    (6,400)    (3,600)

Net Deferred
Tax Asset/
 (Liability)

Account        12/31/99   Tax      Deferred Tax
               Balance    Rate     Asset/(Liability)

Depreciation   7,700      39.47%   $3,039
               (10,000)   39.47%   ($3,947)
               (2,300)

Net Deferred
Tax Asset/                         (908)
 (Liability)

4. Other Temporary Differences

Other areas that may cause a temporary difference(3) include:

* Reserve against income accrued for book purposes for the performance of services that, based on experience, will not be collected (e.g., allowances for bad debt);

* prepaid expenses that cannot be deducted for tax purposes;

* an investment tax credit carried from a prior year;

* expense accruals for which "economic performance" has not occurred;

* stocks or securities deemed worthless but still owned at year-end;

* hedging transactions;

* discharge of debt due to bankruptcy or insolvency;

* a security sold at a loss in respect of which "wash sale" disallowance rules were not considered;

* amortization of original issue discount;

* a loan made to an officer employee or shareholder at a below market interest rate;

* limitations on capital losses;

* depreciation recapture if assets were disposed or retired;

* like-kind exchanges;

* insurance proceeds from an involuntary conversion;

* listed property limitations (e.g., luxury vehicles);

* capitalized leases;

* advance payments for services or goods;

* unearned income treated as deferred income for book purposes;

* charitable contributions that cannot be fully deducted for tax purposes in the current year;

* incentive stock options and non-qualified stock options; and

* net operating losses or capital losses limited pursuant to section 382 as a result of an "ownership change."

Why Deferred Tax Assets Are Bad and Deferred Tax Liabilities Are Good

When a company has a net deferred tax asset, they are paying more tax now than in the future on the accounts that compose the net deferred tax asset.(4) This is because the company is precluded from recognizing current tax deductions or it is recognizing more in taxable income in the current year than in the future with respect to the sum of the accounts that compose the net deferred tax asset. On the other hand, if the company has a net deferred tax liability, it is paying less tax now than it would in the future if these items were treated the same as for book purposes. Thus, the effect of a deferred tax liability is a deferral in paying taxes.

The detriment to paying tax now versus deferral of the tax is the loss of the time-value of money. For example, Company X has a $1,000,000 net deferred tax asset and Company Y has a $1,000,000 net deferred tax liability. Assume that every temporary item will reverse in the subsequent year, there is no valuation allowance (discussed below) to Company X's net deferred tax asset and the current rate of interest is 7 percent. Company X is losing $70,000 based on the time-value of money. Although a deferred tax liability is not a tax-free loan to the IRS, the result is similar.

One benefit of having a deferred tax asset is that it increases the company's gross assets on its balance sheet. Upon the payment of these taxes, however, will be a corresponding reduction in the company's cash.

When a company has a net deferred tax asset, it is losing the battle over the time-value of money. The company should work to minimize a net deferred tax asset or create a net deferred tax liability. One beginning point for this is to conduct a detailed study of the company's fixed assets, which will reveal whether many fixed assets are being depreciated over longer class lives than allowed by the Internal Revenue Code. If a company can depreciate an asset over five years instead of seven and the company has several million dollars invested in these assets, a quicker depreciation schedule can easily create a net deferred tax liability. Other common strategies include requiring employees to receive their bonus and vacation pay no later than 2-1/2 months from year-end. Therefore, if a company has a December 31 year-end, the company could require each employee to use all accumulated vacation time by March 15th (under a "use it or lose it" policy). Additionally, the company could be required to pay all accrued bonuses before the 2-1/2 month expiration. By adopting these simple policies, the company could eliminate many deferred tax assets, thereby accelerating income tax deductions. A final example of a very common deferred tax asset is a company's bad debt reserve or the allowance for doubtful accounts. Such "reserves" are not allowed to be deducted for tax purposes with a few exceptions. By year-end, every company should evaluate this account (and any other reserve) to determine whether they can lower the amount, within the limits provided by GAAP. The smaller the reserve, the smaller the deferred tax asset.

Permanent Differences

Deferred tax liabilities/assets are the tax-effected temporary items. They arise as a result of the deferral of taxable/financial income or tax/book deduction. Permanent differences are differences between book and tax treatment that will never be recouped. Additionally, permanent differences are income statement numbers and are not from the balance sheet. This means that they are current-year income or expense and not year-end balance numbers. The easiest and most common example is meals and entertainment. For book purposes, these expenses are fully subtracted from book income, whereas for tax purposes, the IRS only allows a 50-percent deduction under section 274(n). There cannot be a recovery of this tax deduction preclusion. Other examples of non-tax deductible items are certain officer's life insurance, club dues, fines and penalties, and goodwill from certain stock acquisitions. An example on the income side is municipal bond interest, which is included in income for book purposes but not for tax purposes. Thus, this amount would be a subtraction from book income that will lower the effective tax rate. The detriment of a high effective tax rate is the company is paying a high rate of tax on their book income, which reduces earnings per share.

Effective Tax Rates

Public companies that must report certain financials with the SEC must file Form 10-K pursuant to the Securities Exchange Act of 1934, which contains a footnote on Income Taxes. This footnote requires the company to disclose its effective tax rate either in percentage or in whole dollars. The effective tax rate shows the percentage of taxes paid based on pre-tax book income. A company's actual tax rate may be 40 percent (assuming 35-percent federal rate and net 5-percent state rate), but effective tax rates can and do exceed 100 percent. This is because there may be significant permanent differences that are added to book income. Earnings per share are based on book income net of income tax. If a company has a high effective tax rate, its earnings per share will be less than a company with a low effective tax rate. Additionally, because every 10K is a public document, every company's effective tax rate is in the public domain.

Tax planning will reduce a company's effective tax rate. For example, reducing the taxes paid to state and local jurisdictions is one such planning opportunity. Among the tax-reduction opportunities that should be explored are negotiating with state and local governments to pay less tax because of the employer's benefit to local jobs; moving into a development/enterprise zone that allows for a tax credit or no tax; taking advantage of state and local tax credits; only paying taxes that are owed (i.e., many companies pay tax without investigating where areas of exemption lie) and even establishing an affiliated corporation in an income tax-free state in which to conduct business and avoiding "nexus" with high tax states (or creating a corporation in another state for apportionment dilution).

There are many other areas outside of the state and local arena where there are opportunities to reduce an effective tax rate. For example, for a company that acquires another company's stock in a tax-free reorganization, the goodwill associated with this purchase is often not deductible for tax purposes. This can create a very large permanent difference and a high effective tax rate. If sections 338 and 338(h)(10) are availed of, however, the company will be able to amortize the goodwill over 15 years pursuant to section 197.

Valuation Allowance

If a deferred tax asset is recognized on the balance sheet, FAS 109 requires a reduction in the deferred tax asset by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.(5) This provision is often relevant to new corporations.(6) For example, if a company has a $1 million net operating loss that is the only deferred tax asset and the company only expects to recoup 20 percent of the NOL, then the valuation allowance is 80 percent of the deferred tax asset related to the NOL.

Provision-to-Return Reconciliation

Many companies have different people prepare their tax returns than those that prepared their income tax provision. Tax return preparers are responsible for completing Schedule M-1. Some preparers seemingly disregard the provision, whereas others work directly off the provision in preparing Schedule M-1. Still others use the provision as a guide, but make revisions owing to the discovery of adjustments after the provision is completed.

A provision-to-return reconciliation simply trues up the differences identified by the tax return preparers. It is very important in preparing the subsequent-year provision to identify the changes noted in Schedule M-1. Additionally, if there are any changes in permanent differences, then this must be reconciled to the rate reconciliation.

Income Tax Provision Disclosure Requirements

FAS 109 requires public companies to disclose the total of all deferred tax liabilities, assets, valuation allowance, current tax expense or benefit, deferred tax expense or benefit, investment tax credits, governmental grants, the benefits of operating loss carryforwards, the tax expense related to goodwill or other noncurrent intangible assets of an acquired entity, adjustments to a deferred tax liability or asset for enacted changes in tax laws or rates or change in the tax status of the enterprise, and the rate reconciliation and the amounts and expiration dates of operating loss and tax credit carryforwards for tax purposes.(7) The rate reconciliation discloses the reported amount of income tax expense attributable to continuing operations for the year to the amount of income tax expense that would result from applying domestic federal statutory tax rates to pretax income from continuing operations using percentages or dollar amounts.(8)

Illustrative Template

There are two items that are crucial to completing a provision for a newcomer to FAS 109: a good template and a detailed trial balance. This article concludes with a multi-part example to satisfy the first requirement; for the second, the reader is on his or her own. Often the company will have a balance sheet and an income statement that are given to whoever prepares the provision. By itself, this may only bring questions. For example, on the balance sheet is the term "accrued liabilities." This account will often have some items that create a temporary difference and others that do not. With a detailed trial balance, the preparer can ascertain what items are in accrued liabilities.

The example below is divided into seven tables to illustrate the issues discussed in this article and demonstrate how the provision is prepared. Most numbers are tied to either another table or something in the financial sheets, which themselves are set forth in Tables 5 and 6. This linkage is important for two reasons. One, it allows a reviewer to check the preparer's work. Two, if a new person prepares the provision in subsequent years that person can understand where the numbers came from in prior years.

Table 1: Deferred Tax Assets (Liabilities)

XYZ Corporation
Deferred Tax Assets/Liabilities
12/31/99

                            Deferred Tax           Current
                            Asset (Liability)      Year
                            12/31/98               Activity

Allowance for
 doubtful accounts   Book   BS    15,000      Calc   19,000

Accumulated          Book   BS    320,000     P&L    203,994
 Depreciation        Tax    PY    (594,000)   (1)    (377,842)

Accrued Bonuses      Book   BS    322,000     Calc   (17,000)

Accrued Vacation     Book   BS    325,000     Calc   69,000

Accrued Legal Fees   Book   Bs    150,000     P&L    (150,000)

Total                             538,000            (252,848)

                            (2)   206,000     (2)    (96815)

                             Deferred Tax
                             Asset
                             (Liability)    Tax      Tax
                             12/31/99       Rate     Effect

Allowance for
 doubtful accounts   BS      34,000         38.29%   13,019

Accumulated          BS      523,994        38.29%   200,637
 Depreciation        Calc    (971,842)      38.29%   (372,118)

Accrued Bonuses      BS      305,000        38.29%   116,785

Accrued Vacation     BS      394,000        38.29%   150,863

Accrued Legal Fees           0              38.29%   0

Total                        285,152        38.29%   109,185

Tax Rate

Federal                    34.00%
State (Blended)    6.50%
 Federal benefit   2.21%
Net state rate             4.29%

Total                      38.29%

(1.) Estimate based on last year's proportion of tax depreciation/amortization to book depreciation/amortization (assuming no material acquisitions or retirements).

(2.) Tax effect of total. Compare to Table 3 as check.

BS = Balance Sheet

PY = Prior Year

P&L = Profit & Loss or Income Statement

"Calc = calculation, e.g., ending year balance minus prior year ending balance."

Table 2: Income Tax Provision

XYZ Corporation
Income Tax Provision
12/31/99

                                           With
                                         Temporary
                                        Differences

Book Income (Loss) Before Taxes   P&L     1,708,650

Permanent Items
Non-deductible goodwill           P&L       256,395
50% of Meals and Entertainment    P&L        35,162

Income before temporary
  differences                             2,000,207

State tax expense
Federal benefit of state
  deduction

Temporary Items
Allowance for doubtful accounts   T1         19,000
Depreciation                      T1      (173,848)
Accrued Bonuses                   T1       (17,000)
Accrued Vacation                  T1         69,000
Accrued Legal Fees                T1      (150,000)

Total temporary differences               (252,848)

State Taxable Income              E       1,747,359

State taxes payable               F         113,578

Federal taxable income            G       1,633,781

Federal taxes payable at 34%                555,486

Total tax expense/(benefit)

Statutory Rate Reconciliation
Income before taxes               I         580,941
Effect of permanent differences   J          99,129
Effect of state taxes
 (net of Federal benefit)         K          85,809
Other

                                            765,879

Valuation Allowance                               0

Total                                       765,879

Current vs. Deferred Tax
 Expense/(Benefit)

                                            Current
Federal                           L         555,486
State                             M         113,578

Total                                       669,064

                                      Tax             Rate
                                    Expense      Reconciliation

Book Income (Loss) Before Taxes   A   580,941        34.00%

Permanent Items
Non-deductible goodwill           A    87,174    B   05.10%
50% of Meals and Entertainment    A    11,955    B    0.70%

Income before temporary
 differences

State tax expense                 C   130,013    B   07.61%
Federal benefit of state
 deduction                        D   (44,205)   B   -2.59%

Temporary Items
Allowance for doubtful accounts
Depreciation
Accrued Bonuses
Accrued Vacation
Accrued Legal Fees

Total temporary differences

State Taxable Income

State taxes payable

Federal taxable income

Federal taxes payable at 34%

Total tax expense/(benefit)       H   765,879    B   44.82%

Statutory Rate Reconciliation
Income before taxes                    34.00%
Effect of permanent differences        05.80%
Effect of state taxes
 (net of Federal benefit)              05.02%
Other

                                       44.82%

Valuation Allowance                     0.00%

Total                                  44.82%

Current vs. Deferred Tax
 Expense/(Benefit)

                                      Deferred         Total

Federal                           N   124,585    O   680,070
State                             N   (27,769)   K    85,809

Total                                   96,815       765,879

A. Numbers in column entitled "With temporary differences" are multiplied by the federal rate of 34%.

B. Tax expense divided by book income before taxes.

C. Income before temporary difference multiplied by the state tax (blended) rate.

D. State tax expense multiplied by a negative federal tax rate (i.e., -34%).

E. Income before temporary differences plus total temporary differences.

F. State taxable income multiplied by state tax (blended) rate.

G. State taxable income minus state taxes payable; if state taxes payable is negative, use state taxable income.

H. Sum of the tax expense column.

I. Tax expense of book income.

J. Tax Expense of the sum of the permanent items.

K. State tax expense plus the federal benefit of state deduction.

L. Federal taxes payable at 34%.

M. State taxes payable.

N. Total expense minus current tax expense.

O. Tax expense of book income plus the tax expense of the permanent items.

T1: From Table 1 current year activity

Table 3: Deferred Tax Comparison

XYZ Corporation
Deferred Tax Comparison
12/31/99

                                 T1               PY
                              12/31/99         12/31/98
Deferred Tax Assets:
 Net Operating Loss
 Allowance for doubtful             --                         --
  accounts                  T1  13,019                  A   5,744
 Accrued bonuses            T1 116,785                  A 123,294
 Accrued vacation           T1 150,863                  A 124,443
 Accrued legal fees         T1      --                  A  57,435

                               280,666                    310,915

Deferred Tax Liabilities:
 Accrued depreciation       T1 (171,481)                A (104,915)

                            $  (171,481)                $ (104,915)

Valuation Allowance                   0                          0

Deferred Tax Asset/
 (Liability), Net           T1 109,185                  T1 206,000

                               Current           Change in
                               Payable           Deferred Asset

                            T2 669,064                  T2  96,815
                                                  Sum (B)= (96,815)
                               Difference/Check                  0

                            Flux equals
                            1999 Activity
Deferred Tax Assets:
 Net Operating Loss
 Allowance for doubtful
  accounts                  B    7,275
 Accrued bonuses            B  (6,509)
 Accrued vacation           B   26,420
 Accrued legal fees         B (57,435)

                              (30,249)

Deferred Tax Liabilities:
 Accrued depreciation       B (66,566)

                              (66,566)

Valuation Allowance                  0

Deferred Tax Asset/
 (Liability), Net             (96,815)

                             Provision for

                             Income Taxes

                               765,879

A. Numbers are from T1 for 12/31/98 multiplied by the tax rate (i.e., 38.29%).

B. 1999 minus 1998.

T1 Table 1: Tax effected numbers.

Table 4: Tax Footnote Disclosure

XYZ Corporation
Tax Footnote Disclosure
12/31/99

The components of the deferred tax provision, which arise from
temporary differences between financial and tax reporting, are
presented below:

                                          12/31/99

Current tax expense                        699,064

Deferred tax expense/(benefit)              96,815

Total tax expense or provision
  for income tax                           765,879

Variations from the federal
  statutory rate are as follows:

Expected federal income tax expense
  at statutory rate of 34%

Effect of permanent differences       T2   580,941
State income tax expense net          T2    99,129
  of federal benefit                  T2    85,809

Income tax expense                         765,879

The components of the net accumulated deferred income tax liability
as of December 31, 1998 and 1999 are as follows:

Deferred Tax Assets:
  Allowance for doubtful accounts
  Accrued bonuses                         12/31/99
  Accrued vacation                    T3    13,019
  Accrued legal fees                  T3   116,785
                                      T3   150,863

Deferred Tax Assets                   T3         0

Deferred Tax Liabilities                   280,666

 Accumulated depreciation             T3 (171,481)

Deferred Tax Liabilities                 (171,481)

Valuation Allowance                              0

Net deferred tax assets/
  (liabilities)                            109,185

                                        Balance Sheet

Current tax expense                   (1)
Deferred tax expense/(benefit)        (2)
Total tax expense or provision
  for income tax

Variations from the federal
  statutory rate are as follows:
Expected federal income tax expense
  at statutory rate of 34%                  34.00%
Effect of permanent differences              5.80%
State income tax expense net                 5.02%
  of federal benefit

Income tax expense                          44.82%

The components of the net accumulated deferred income tax liability
as of December 31, 1998 and 1999 are as follows:

Deferred Tax Assets:                      12/31/98           Flux
  Allowance for doubtful accounts     T3     5,744
  Accrued bonuses                     T3   123,294
  Accrued vacation                    T3   124,443
  Accrued legal fees                  T3    57,435

Deferred Tax Assets                        310,915

Deferred Tax Liabilities

 Accumulated depreciation             T3 (104,915)

Deferred Tax Liabilities                 (104,915)
Valuation Allowance                              0

Net deferred tax assets/
  (liabilities)                            206,000         (96,815)

                                      Balance Sheet           P&L

(1.) Represents the current federal taxes plus state.

(2.) Represents the flux between PY ending balance and current year ending balance of the deferred tax asset/liability account. See flux above.

Table 5: December 31, 1999, Balance Sheet

XYZ Corporation
Balance Sheet
December 31, 1999

                                     Beginning    Ending

ASSETS

Current Assets:
Cash                                   120,000       80,000
Accounts Receivable                     90,000      101,000
Allowance for Doubtful Accounts       (15,000)     (34,000)
Merchandise Inventory                  250,000      340,000
Total Current Assets                   445,000      487,000

Long Term Assets
Plant & Equipment                    1,200,000    1,340,000
Land                                   500,000      480,000
Building                               430,000      400,000
Software                               120,000      140,000
Accum Depreciation                   (320,000)    (523,994)
Total Long-Term Assets               1,930,000    1,836,006

Total Assets                         2,375,000    2,323,006

LIABILITIES

Accounts payable                       240,000      330,000
Accrued Bonus                          322,000      305,000
Accrued Vacation                       325,000      394,000
Accrued Legal                          150,000            0

Total Liabilities                    1,037,000    1,029,000

Stockholders Equity
Paid in capital                      1,200,000    1,200,000
Retained Earnings                      138,000       94,006
Total Stockholders Equity            1,338,000    1,294,006

Total Liabilities and                2,375,000    2,323,006
 Stockholders Equity

Table 6: December 31, 1999, Income Statement

XYZ Corporation
Income Statement
For Year Ended December 31, 1999

Sales
Less
Sales returns and allowances                   94,000
Sales discounts                                21,000
Net Sales

Cost of Goods Sold
Beginning Inventory,
Jan. 1, 1999
Purchases                                   4,980,000
Less:
Purchases returns and allowances   90,000
Purchase discounts                 35,000     125,000
Net Purchases                               4,855,000
Add: Transportation                            25,000
Cost of Merchandise purchased
Merchandise available for sale
Less ending inventory
December 31, 1999
Cost of Merchandise sold
Gross Profit on Sales

Operating Expenses
Selling Expenses:
Sales salaries expense                        380,000
Advertising Expense                           140,000
Bad debt expense                               19,337
Total selling expense
Administrative expenses:
Office Salaries expense                       204,000
Rent expense                                  240,000
Depreciation expense                          203,994
Insurance expense                              54,000
Office Supplies expense                        21,000
Legal Expense                                 150,000
Bonus Expense                                  88,000
Vacation Expense                              140,000
Meals & Entertainment                          70,324
Misc Expense                                    8,200
Total Admin expenses
Total Operating Expenses
Income from Operations
Other income
Interest income                                 2,400
Rental income                                  45,000
Other expenses:
Goodwill                                      256,395
Interest expense:                               1,500

Net income before taxes

Sales                              8,543,000
Less
Sales returns and allowances
Sales discounts                      115,000
Net Sales                                      8,428,000

Cost of Goods Sold
Beginning Inventory,
Jan. 1, 1999                         250,000
Purchases
Less:
Purchases returns and allowances
Purchase discounts
Net Purchases
Add: Transportation
Cost of Merchandise purchased      4,880,000
Merchandise available for sale     5,130,000
Less ending inventory
December 31, 1999                    340,000
Cost of Merchandise sold                       4,790,000
Gross Profit on Sales                          3,638,000

Operating Expenses
Selling Expenses:
Sales salaries expense
Advertising Expense
Bad debt expense
Total selling expense                539,337
Administrative expenses:
Office Salaries expense
Rent expense
Depreciation expense
Insurance expense
Office Supplies expense
Legal Expense
Bonus Expense
Vacation Expense
Meals & Entertainment
Misc Expense
Total Admin expenses               1,179,518
Total Operating Expenses                       1,718,855
Income from Operations                         1,919,145
Other income
Interest income
Rental income                         47,400
Other expenses:
Goodwill
Interest expense:                                257,895

Net income before taxes                        1,708,650

Table 7: Journal Entries

XYZ Corporation
Journal Entries
12/31/99

                                     Income Statement

                                    Debit     Credit
Current Tax Expense              T4 669,064
Taxes Payable
Deferred Tax Asset/(Liability)
Deferred Tax Expense\(Benefit)   T4 96,815

                                     Balance Sheet

                                    Debit      Credit
Current Tax Expense
Taxes Payable                               T4 669,064
Deferred Tax Asset/(Liability)              T4  96,815
Deferred Tax Expense\(Benefit)

(1) Schedule M-1 is the section of the Form 1120 that details book-to-tax differences, both permanent and temporary.

(2) See Treas. Reg. [subsections] 1.404(b)-1T A-2(b)(1).

(3) Some of these may also the permanent difference rules, which are discussed in the text that follows.

(4) This is the case unless the company has significant net operating losses that preclude the payment of future taxes.

(5) FAS 109, Paragraphs 17, 20, 23 and 24.

(6) Additionally, start-up companies often have a net deferred tax asset as a result of the expenses incurred before the company was active and organizational costs. These expenses are not deductible for tax purposes and must be amortized over 60 months. See I.R.C. [subsections] 195 and 248.

(7) FAS 109, Paragraphs 43, 45, and 48.

(8) FAS 109, Paragraph 47.

AARON SHALL is a senior tax consultant with Ernst & Young, LLP in Denver, Colorado. He focuses on clients in the telecommunications industry, specializing on state and local tax, net operating loss limitations, basic international tax, and mergers and acquisitions. Mr. Schaal received his J.D. degree from Campbell University and LL.M. degree from Denver University.