Deferred income tax

What Is Deferred Income Tax?

Deferred income tax refers to the accounting treatment of income tax consequences arising from temporary differences between the carrying amounts of assets and liabilities in a company’s financial statements and their corresponding tax bases. It falls under the broader category of financial accounting, specifically dealing with how companies report their tax obligations. These temporary differences occur because the rules for financial reporting, such as those governed by GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards), often differ from the rules for calculating taxable income for tax purposes. Deferred income tax can manifest as either a deferred tax asset (DTA) or a deferred tax liability (DTL), representing future tax benefits or obligations, respectively.

History and Origin

The concept of deferred income tax emerged as financial accounting standards evolved to provide a more accurate representation of a company's financial position and performance, moving beyond simply reporting taxes currently payable. Early attempts at accounting for income taxes, such as Accounting Principles Board (APB) Opinion 11, introduced the deferred method in 1967 to reconcile differences between book and tax income. H²⁸owever, these early standards proved complex. The Financial Accounting Standards Board (FASB) significantly revised this with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," issued in 1992, and now codified primarily under ASC 740. T²⁷his standard mandates an asset and liability approach, where deferred taxes are recognized for the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and their amounts for income tax purposes. T²⁴, ²⁵, ²⁶his framework aims to ensure that the current and future tax consequences of a company's activities are recognized in the same reporting period as the related book income or loss.

²³## Key Takeaways

• Deferred income tax arises from temporary differences between financial accounting rules and tax laws.
• It results in either a deferred tax asset (future tax benefit) or a deferred tax liability (future tax obligation).
• The measurement of deferred income tax is based on enacted tax laws and rates, not anticipated future changes.
• A valuation allowance may be required to reduce deferred tax assets if their realization is not probable.
• Deferred income tax provides users of financial statements with a more comprehensive view of a company's long-term tax position.

Formula and Calculation

The core principle behind calculating deferred income tax involves identifying temporary differences and applying the enacted future tax rates.

Deferred Tax Liability (DTL) or Asset (DTA) is calculated as:

$\text{Deferred Tax} = (\text{Book Value of Item} - \text{Tax Basis of Item}) \times \text{Enacted Future Tax Rate}$

Alternatively, it can be viewed as:

$\text{Deferred Tax Expense (Benefit)} = \text{Total Tax Expense} - \text{Current Tax Expense}$

Where:

• Book Value of Item: The value of an asset or liability as reported in the company's balance sheet according to GAAP or IFRS.
• Tax Basis of Item: The value of the same asset or liability as determined by tax laws for calculating taxable income.
• Enacted Future Tax Rate: The tax rate that is expected to apply when the temporary difference reverses. This rate must be one that has already been signed into law.
• Total Tax Expense: The amount reported on the income statement that reflects both current and deferred tax impacts.
• Current Tax Expense: The amount of tax currently payable or refundable based on the current period's taxable income.

Temporary differences arise from various sources, such as differing depreciation methods, revenue recognition timing, or accruals for expenses that are deductible for tax purposes only when paid.

²¹, ²²## Interpreting the Deferred Income Tax

Deferred income tax balances provide crucial insights into a company's financial health and future tax landscape. A deferred tax liability indicates that a company has recognized income for accounting purposes that has not yet been taxed. This typically means the company will pay more taxes in the future as these differences reverse. Conversely, a deferred tax asset suggests that a company has paid more taxes or recognized fewer deductions for tax purposes than for financial reporting, implying future tax savings.

Analysts often examine the components of deferred tax assets and liabilities to understand the quality of a company's earnings and its future cash flow implications. For instance, a large deferred tax asset due to net operating loss carryforwards might indicate past financial difficulties, but also potential future tax shields if the company returns to profitability. It's important to consider any associated valuation allowance that may reduce the recognized value of deferred tax assets if their realization is uncertain.

¹⁹, ²⁰## Hypothetical Example

Imagine "Tech Innovations Inc." purchases new machinery for $1,000,000. For financial reporting (GAAP), the company depreciates the machinery straight-line over 10 years, resulting in an annual depreciation expense of $100,000. However, for tax purposes, the tax law allows for accelerated depreciation, enabling the company to deduct $200,000 in the first year. The corporate tax rate is 25%.

Year 1:

• GAAP Depreciation: $100,000
• Tax Depreciation: $200,000

The difference between GAAP and tax depreciation is a temporary difference of $100,000 ($200,000 - $100,000). Since the company deducted more for tax purposes initially, its taxable income is lower than its book income, resulting in lower current taxes paid. This creates a deferred tax liability, as the company will have smaller depreciation deductions for tax purposes in later years, leading to higher taxable income and higher taxes then.

Calculation:
Temporary difference = $100,000 (tax deduction exceeds book deduction)
Deferred Tax Liability = $100,000 (temporary difference) × 25% (tax rate) = $25,000

This $25,000 would be recorded as a deferred tax liability on Tech Innovations Inc.'s balance sheet and as a deferred tax expense on its income statement for the period. Over the life of the asset, these differences will reverse, and the deferred tax liability will unwind.

Practical Applications

Deferred income tax impacts various aspects of financial analysis and corporate strategy. In financial analysis, understanding deferred tax balances is critical for evaluating a company's true profitability and future cash flow generation. Investors and creditors use this information to assess the sustainability of earnings quality and a firm's ability to meet future tax obligations.

F¹⁷, ¹⁸or example, when examining a company's corporate tax expense, analysts typically look at both the current portion (taxes payable) and the deferred portion. The Securities and Exchange Commission (SEC) requires detailed disclosures regarding deferred tax assets and liabilities in public company filings, providing transparency into these items. An example of such disclosures can be found in SEC filings. These disclosures often break down the significant components of deferred taxes, such as those related to property, plant, and equipment, or net operating loss carryforwards. Co¹⁴, ¹⁵, ¹⁶mpanies also use deferred tax considerations in tax planning strategies to optimize their tax position within legal frameworks.

Limitations and Criticisms

Despite its importance, accounting for deferred income tax can be complex and has faced criticisms. One major point of contention is the difficulty in estimating future tax rates and the probability of realizing deferred tax assets. While standards require using currently enacted tax rates, legislative changes can occur, impacting the value of deferred tax balances.

A¹², ¹³nother criticism revolves around the subjective nature of the valuation allowance applied to deferred tax assets. Management judgment is involved in assessing whether it is "more likely than not" that deferred tax assets will be realized. If not, a valuation allowance is recorded, reducing the asset. This judgment can sometimes be a point of scrutiny for regulators and auditors, as it can significantly impact reported earnings. So⁹, ¹⁰, ¹¹me research suggests that the complexity of deferred taxes may provide opportunities for earnings management, where companies might strategically recognize or derecognize deferred tax items to smooth reported profits. Th⁵, ⁶, ⁷, ⁸e very nature of deferred taxes, as a forward-looking accounting estimate, introduces a degree of uncertainty compared to current tax obligations. Academic reviews highlight the ongoing debates among standard-setters and researchers regarding the informativeness and practical application of deferred tax accounting.

#³, ⁴# Deferred Income Tax vs. Current Income Tax

Deferred income tax and current income tax both relate to a company's tax obligations, but they differ fundamentally in their timing and basis of calculation.

The confusion between the two often stems from the fact that both contribute to the total tax expense reported on a company's income statement. While current income tax reflects the immediate tax impact, deferred income tax provides a crucial bridge between a company's accounting profit and its taxable profit over time, offering a more complete picture of its tax position.

FAQs

Why is deferred income tax necessary?

Deferred income tax is necessary because financial accounting standards (like GAAP) and tax laws have different rules for recognizing revenues and expenses. This creates "temporary differences" in how income is calculated for a company's financial reports versus its tax returns. Deferred income tax ensures that a company's financial statements accurately reflect the total tax consequences of its operations, matching the tax effect to the period in which the related income or expense is recorded.

What causes deferred income tax?

Deferred income tax arises primarily from "temporary differences" between the book basis (used for financial reporting on the balance sheet) and the tax basis (used for calculating taxable income) of assets and liabilities. Common causes include differences in depreciation methods, revenue recognition for installment sales, bad debt allowances, and expenses that are deductible for tax purposes only when paid.

Is deferred income tax a real cash expense?

No, deferred income tax itself is not a current cash expense or payment. It represents a non-cash adjustment on the income statement that reflects future tax obligations (deferred tax liabilities) or future tax benefits (deferred tax assets). The actual cash tax paid or received is represented by the "current income tax expense" or "income tax payable."

How do changes in tax rates affect deferred income tax?

When tax rates change, companies must revalue their existing deferred tax assets and liabilities using the newly enacted rate. This adjustment is typically recognized in the period the tax law change is enacted and impacts the company's total tax expense on its income statement. For example, a decrease in the corporate tax rate would reduce the value of a deferred tax liability and decrease tax expense, while reducing the value of a deferred tax asset and increasing tax expense.

Where can I find deferred income tax information in a company's financial statements?

Information on deferred income tax is typically found in the income tax footnote disclosures to a company's financial statements, usually within its annual report. These disclosures provide a breakdown of the deferred tax assets and liabilities, the components of income tax expense, and a reconciliation of the statutory tax rate to the effective tax rate. You can often find these in regulatory filings, such as those made with the SEC.¹, ²