Slightly broader than timing differences.b: Explain why and how deferred tax liabilities and assets are created.A deferred tax asset occurs when taxable income exceeds pretax income and this difference will reverse in the future. For example, pretax income includes an accrual for warranty expense but warranty cost is not deductible for taxable income until the firm has made actual expenditures to meet warranty claims.Example: Let a firm have sales of $5,000 for each of two years. It estimates that warranty expense to be 2% of year 1 sales or $100. No warranty is given for year 2 sales. The actual expenditure of $100 to meet warranty claims was not made until the second year. Assume a tax rate of 40%. Taxable income for two years appears below. Year 1 Year 2
 

　　Revenue $5000 $5000

　　Warranty expense 0 100

　　Taxable income 5000 4900

　　Taxes payable 2000 1960

　　Net income 3000 2940
 

　　In this example: year 1 tax expense (on financial statements) is $1,960 although taxes payable is $2,000. The difference of $40 (taxes paid greater than tax expense) is a deferred tax asset. In the second year, the temporary difference associated with warranties is reversed when tax expense of $2,000 is $40 more than taxes payable of $1,960.c: Describe the liability method of accounting and deferred taxes.In the US the liability method (SFAS 109) replaced the deferral method (APB 11) of accounting for tax expense. The deferral method of calculating deferred tax expense using current tax rates with no adjustment for tax rate changes is now used in only a few countries. The liability method’s focus is on the measurement of deferred tax assets or liabilities associated with temporary (reversing) differences in taxable income (IRS) and pretax income (GAAP). The deferred asset or liability is measured at the tax rate that exists when the reversing event occurs (usually the current tax rate) and deferred tax expense is the sum (difference) of the increase (decrease) in the deferred tax liability and taxes payable. The major difference between the deferral method and liability method is the treatment of changes in tax rates. The deferral method is unaffected by changes in tax rates while the liability method adjusts deferred assets and liabilities to reflect the new tax rates.d: Explain the factors that determine whether a company's deferred tax liabilities should be treated as a liability or as equity for purposes of financial analysis.If deferred assets or liabilities are expected to reverse in the future, then they are best classified as assets or liabilities. If however, they are not expected to reverse in the future, then they are best classified as equity. Deferred taxes in many cases (firm growth, changes in tax laws, or firm operations), may be unlikely to be paid. Even if they are paid, deferred taxes should be carried at present value (they are not). If it is determined that deferred taxes are not a liability (i.e., nonreversal is certain), then deferred taxes is stockholders’ equity. This decreases the debt-to-equity ratio, sometimes significantly. Sometimes, instead of reclassifying deferred liabilities as stockholders’ equity, the analyst might just ignore deferred taxes altogether. This is done if nonreversal is uncertain or financial statement depreciation is deemed inadequate and is therefore difficult to justify an increase in stockholders’ equity. Some creditors, notably banks, simply ignore deferred taxes. The analyst must decide on the appropriate treatment of deferred taxes on a case by case basis.e: