What Is Deferred Income Tax?
Deferred income tax represents the future tax consequences of events that have been recognized in an entity's financial statements or tax returns. It is a concept within financial accounting that arises due to temporary differences between a company's financial reporting (book) profit and its taxable income. These differences occur because various revenues and expenses are recognized at different times for accounting purposes compared to tax purposes. A deferred income tax liability indicates that a company will pay more income tax in the future, while a deferred income tax asset suggests the company will pay less income tax in the future.
History and Origin
The concept of accounting for income taxes, including deferred income tax, has evolved significantly with the development of modern accounting standards. Prior to the late 20th century, the approach to income tax accounting was less standardized, leading to inconsistencies in financial reporting.
In the United States, the Financial Accounting Standards Board (FASB) established Accounting Standards Codification (ASC) Topic 740, Income Taxes, as the authoritative guidance for how companies must account for income taxes on their financial statements under U.S. Generally Accepted Accounting Principles (GAAP). ASC 740 dictates the recognition, measurement, presentation, and disclosure of income tax-related items.8
Internationally, the International Accounting Standards Board (IASB) issued IAS 12, Income Taxes, which prescribes the accounting treatment for income taxes under International Financial Reporting Standards (IFRS). IAS 12 was originally issued by the International Accounting Standards Committee in October 1996 and adopted by the IASB in April 2001.6, 7 Both ASC 740 and IAS 12 adopt a balance sheet approach to income tax accounting, recognizing the future tax consequences of the recovery or settlement of assets and liabilities.4, 5
Key Takeaways
- Deferred income tax arises from timing differences between when income and expenses are recognized for financial reporting versus tax purposes.
- It is categorized as either a deferred tax asset (future tax savings) or a deferred tax liability (future tax payments) on the balance sheet.
- The calculation involves identifying temporary differences and applying the enacted future tax rate.
- Changes in tax laws or rates can significantly impact the value of a company's deferred income tax balances.
Formula and Calculation
Deferred income tax is not calculated using a single, overarching formula, but rather results from the aggregation of the tax effects of individual temporary differences. The core principle involves multiplying the temporary difference by the expected future tax rate.
A deferred tax liability arises when the tax base of an asset is less than its carrying amount, or the tax base of a liability is greater than its carrying amount, leading to future taxable amounts.
A deferred tax asset arises when the tax base of an asset is greater than its carrying amount, or the tax base of a liability is less than its carrying amount, leading to future deductible amounts.
The general relationship can be expressed as:
For example, if a company uses different depreciation methods for accounting and tax purposes, a temporary difference is created. If accelerated depreciation is used for tax and straight-line for accounting, the tax depreciation will initially be higher, resulting in lower current taxable income and a deferred tax liability, which will reverse as the asset ages.
Interpreting the Deferred Income Tax
Interpreting deferred income tax requires understanding its nature as a future financial obligation or benefit. A deferred tax liability indicates that a company has paid less tax in the current period than it expects to pay in the future, often due to accelerated deductions for tax purposes or revenue recognized earlier for financial reporting. This suggests future cash outflows for taxes.
Conversely, a deferred tax asset implies that a company has paid more tax currently or expects future tax deductions, resulting in future tax savings or refunds. This can arise from expenses recognized earlier for financial reporting (e.g., warranty provisions) or slower depreciation for tax purposes. The realization of deferred tax assets is contingent on the company generating sufficient future accounting profit against which these benefits can be utilized. Companies must assess the likelihood of realizing these assets and, if it is not "more likely than not," a valuation allowance is recognized to reduce the deferred tax asset to its realizable amount.
Hypothetical Example
Consider Company A, which purchases a new machine for $100,000. For financial reporting under GAAP, it uses the straight-line depreciation method over 10 years, resulting in an annual depreciation expense of $10,000. For tax purposes, however, the government allows accelerated depreciation, and Company A can deduct $25,000 in the first year. The corporate tax rate is 25%.
In Year 1:
- Financial Reporting Depreciation: $10,000
- Tax Depreciation: $25,000
This creates a temporary difference of $15,000 ($25,000 - $10,000). Because Company A deducted more for tax than for financial reporting, its current taxable income is lower, leading to lower current taxes. However, this difference will reverse in future years when tax depreciation becomes less than financial depreciation.
To account for this, Company A recognizes a deferred income tax liability:
Deferred Tax Liability = Temporary Difference × Tax Rate
Deferred Tax Liability = $15,000 × 25% = $3,750
This $3,750 is recorded on the balance sheet as a deferred tax liability, signifying that Company A will owe this amount in future taxes when the temporary difference reverses. If Company A operated under IFRS, the accounting treatment would follow similar principles under IAS 12.
Practical Applications
Deferred income tax is a crucial component in financial reporting and analysis, providing insights into a company's future tax obligations and benefits. In financial analysis, understanding deferred tax balances can help evaluate the quality of earnings and forecast future cash flows related to taxation.
For instance, a company with significant deferred tax liabilities often implies past tax benefits (e.g., accelerated depreciation or deferred revenue recognition for tax purposes), which will eventually lead to higher cash tax payments in the future. Conversely, large deferred tax assets may signal future tax savings, though their realization depends on future profitability.
Furthermore, deferred income tax plays a role in mergers and acquisitions, as the acquiring company must consider the deferred tax assets and liabilities of the target company during valuation. Changes in tax legislation, such as the U.S. Tax Cuts and Jobs Act of 2017, can significantly impact deferred tax balances, requiring companies to re-measure their deferred tax assets and liabilities to reflect the new rates. The Securities and Exchange Commission (SEC) staff issued guidance, such as Staff Accounting Bulletin (SAB) 118, to assist registrants in accounting for the income tax effects of such legislative changes.
2, 3## Limitations and Criticisms
Despite its importance, accounting for deferred income tax can be complex and subject to various criticisms. One primary limitation is the inherent estimation involved. Calculating deferred tax balances requires assumptions about future tax rates and the timing of reversals of temporary differences. These estimates can be challenging, especially for companies with complex operations or those operating in multiple tax jurisdictions.
The different approaches to accounting for income and expenses for tax versus financial reporting, as outlined by regulatory bodies like the Internal Revenue Service (IRS) in publications such as IRS Publication 538 on accounting periods and methods, contribute to this complexity. T1his divergence can make the reconciliation of accounting profit to taxable income intricate.
Another criticism revolves around the subjective nature of recognizing a valuation allowance for deferred tax assets. Management judgment is required to determine whether it is "more likely than not" that deferred tax assets will be realized. If future taxable income forecasts are overly optimistic, a deferred tax asset may be overstated, potentially misleading investors. Significant changes in a company's business outlook or tax laws can necessitate large adjustments to valuation allowances, impacting reported earnings.
Deferred Income Tax vs. Current Income Tax
While both relate to a company's tax expense, deferred income tax and current income tax reflect different aspects of a company's tax position.
- Current Income Tax: This refers to the amount of tax payable (or refundable) to tax authorities for the current period's taxable income. It is typically based on the tax laws and rates applicable to the current period and represents the portion of the income tax expense that is due immediately or in the near future. It is a direct reflection of the tax liability arising from a company's operations in a given period.
- Deferred Income Tax: As discussed, this accounts for the future tax consequences of temporary differences between financial accounting and tax accounting. It does not represent an immediate cash outflow or inflow but rather an adjustment to reflect the tax effects that will reverse in future periods. It is recorded on the balance sheet as an asset or liability, reflecting future tax implications.
The total income tax expense reported on a company's income statement is the sum of its current income tax expense and the change in its net deferred income tax position for the period.
FAQs
Why do companies have deferred income tax?
Companies have deferred income tax because generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) often require different timing for recognizing revenues and expenses compared to tax laws. These "timing differences" lead to discrepancies between a company's financial accounting profit and its taxable income, creating future tax obligations or benefits that are captured as deferred income tax.
Is deferred income tax an asset or a liability?
Deferred income tax can be either an asset or a liability. It is a deferred tax asset when a company has overpaid taxes or expects future tax deductions, leading to future tax savings. It is a deferred tax liability when a company has understated its current tax expense due to recognizing revenue later for tax purposes (revenue recognition) or expenses earlier for tax purposes (expense recognition), meaning it will owe more tax in the future.
How do changes in tax rates affect deferred income tax?
Changes in enacted tax rates directly impact the value of existing deferred income tax assets and liabilities. When tax rates increase, a deferred tax liability will increase in value (meaning the company will owe more in the future), and a deferred tax asset will also increase (meaning future savings are worth more). Conversely, a decrease in tax rates will reduce the value of both deferred tax assets and liabilities. These adjustments are typically recognized in the period the tax law change is enacted.