Question

Assuming all else equal, discuss the effect of the recognition of the $10 bad-debt expense on the following two tax-related accounts: Current tax liability, Deferred tax asset (or deferred tax liability) tax rate 30%, You need to relate your discussions to the current tax worksheet as well as deferred tax worksheet.

Answer 1

A bad debt expense is recognized when a receivable is no longer collectible because a customer is unable to fulfill their obligation to pay an outstanding debt due to bankruptcy or other finanacial problems. Comapnies that extend credit to their customers report bad debts as an allowance for doubtful accounts on the balance sheet, which is also known as a provision for credit losses.

Current Tax Liabilty: Tax Liability is the amount of money you owe to tax authorities, such as your local, state and federal governments. Tax liabilities are current liabilities. Current liabilities are short-term debts which you must pay within a year. Current Tax is the amount of income tax determined to be payable (recoverable) in respect of the taxable income for a peroid.

Example of Current Tax Liability

Taxes on earned income are the most common type of tax liability. Mr. X earns $50,000 in gross income, reported on a W-2 form to the Internal revenue Service (IRS). At a federal tax rate of 30%, the income tax liability of Mr. X is $15,000.

Deferred Tax: The tax effect on the timing differences is termed as deferred tax which literally means taxes which are deferred. These defrerred taxes are given effect to in the financial statements through Deferred Tax Asset and Deferred Tax Liability as under:

S.NO.	Entity Profit Status	Entity-Current	Entity-Fututre	Effect
1.	Book Profit higher than the Taxable profit	Pay less tax now	Pay more tax in future	Creates Deferred Tax Liability (DTL)
2.	Book Profit less than the Taxable profit	Pay more tax now	Pay less tax in future	Creates Deferred Tax Asset (DTA)

Example of Deferred Tax Asset (DTA) and Deferred Tax Liability (DTL)

DTA - If we take an example to understand this, let us assume that the book profit of an entity before tax is $100 and this includes provision for bad debts of $10. For the purpose of tax profit, bad debts will be allowed in future when it's actually written off. Hence, taxable income after this disallowance will be $110 and as it is mentioned in the question that the income tax rate is 30% then the entity will pay taxes on $110 i.e., (110*30%) $33.

If bad debts were not disallowed, entity would have paid tax on $100 i.e., (100*30%) $30. For the additional $3 which is already paid now, we have to create DTA. The entry for recording DTA is as under:

Deferred Tax Asset A/c Dr $3

To Profit & Loss A/c $3

(Being DTA of $3 accounted in the books)

DTL -  Common example of DTL would be depreciation. When the depreciation rate as per Income Tax Act is higher than the depreciation rate as per companies act , entity will end up paying less tax for the current period. This will create deffered tax liability in the books:

High deduction as per Income Tax Act

Reduction in the Incomer Tax Profit

Pay less tax for the current peroid

Creates future deferred Tax liabilit

The entry for recording DTA is as under:

Profit & Loss A/c Dr

To Deferred Tax Liabilty A/c  

Both the entries are not passed but only liability or asset is created for net amount of deferred tax liability.

Some important points need to be remembered for DTA and DTL:

• If book profit is greater than taxable profit, create deferred tax liability.
• If book profit is less than taxable profit, create deferred tax asset.
• If there is loss in the books of accounts but profit as per income tax and the difference subject to adjustments in future, create deferred tax asset.
• If there is profit in the books of accounts but loss as per income tax and carry forward of loss is allowed, it creates deferred tax liability.