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Deferred tax

What Is Deferred Tax?

Deferred tax represents the future tax consequences of events that have already been recognized in a company's financial statements but have not yet affected its taxable income. It is a fundamental concept within financial accounting, specifically dealing with the differences that arise when accounting rules and tax laws diverge. These differences, known as temporary differences, occur because the timing of revenue and expense recognition for financial reporting purposes may not align with their recognition for tax purposes. Deferred tax impacts a company's balance sheet as either a deferred tax asset or a deferred tax liability, and its corresponding tax expense on the income statement.

History and Origin

The concept of deferred tax emerged from the need to accurately reflect the tax implications of financial transactions over time, particularly as accounting and tax rules became more complex and disparate. Before the formalization of deferred tax accounting, companies often reported current tax payments as their tax expense, which could distort their financial performance.

In the United States, the Financial Accounting Standards Board (FASB) developed Accounting Standards Codification (ASC) Topic 740, Income Taxes, to govern the accounting for income taxes under GAAP. This standard adopted a balance sheet approach, focusing on the differences between the carrying amounts of assets and liabilities in the financial statements and their corresponding tax base. Similarly, internationally, the International Accounting Standards Board (IASB) issued IAS 12 Income Taxes in October 1996 (adopted by the IASB in April 2001) to prescribe the accounting treatment for income taxes under IFRS.4 These standards aimed to provide a comprehensive view of a company's tax position, reconciling the tax expense reported in the financial statements with the taxes actually paid or payable. The complexity of applying these standards can be significant, particularly during periods of major tax reform, as highlighted by the U.S. Securities and Exchange Commission's (SEC) issuance of Staff Accounting Bulletin No. 118 (SAB 118) in response to the Tax Cuts and Jobs Act of 2017.3

Key Takeaways

  • Deferred tax arises from temporary differences between the accounting treatment of items for financial reporting and their treatment for tax purposes.
  • It can result in either a deferred tax asset (a future tax benefit) or a deferred tax liability (a future tax obligation).
  • Deferred tax balances are crucial for understanding a company's true financial performance and future cash flows related to taxes.
  • The calculation involves identifying temporary differences, applying the enacted future tax rates, and considering valuation allowances for deferred tax assets.
  • Major accounting standards like ASC 740 (U.S. GAAP) and IAS 12 (IFRS) provide the framework for deferred tax accounting.

Formula and Calculation

Deferred tax balances are calculated by identifying the temporary differences between the carrying amount of assets and liabilities on the balance sheet and their respective tax bases. The formula for a deferred tax balance is:

Deferred Tax Balance=(Carrying Amount−Tax Base)×Future Enacted Tax Rate\text{Deferred Tax Balance} = (\text{Carrying Amount} - \text{Tax Base}) \times \text{Future Enacted Tax Rate}

Where:

  • Carrying Amount: The value of an asset or liability as reported on the financial statements.
  • Tax Base: The amount attributed to an asset or liability for tax purposes.
  • Future Enacted Tax Rate: The tax rate expected to apply when the temporary difference reverses.

If the carrying amount of an asset exceeds its tax base, it typically results in a deferred tax liability, meaning more tax will be payable in the future when the difference reverses. Conversely, if the tax base of an asset exceeds its carrying amount, or if there are deductible temporary differences (e.g., net operating loss carryforwards), it creates a deferred tax asset, indicating a future tax reduction.

Interpreting the Deferred Tax

Interpreting deferred tax requires understanding the underlying temporary differences that create them. A deferred tax liability often indicates that a company has recognized more income or fewer expenses for accounting purposes than for tax purposes in the current period, leading to a deferral of tax payments to the future. Common examples include accelerated depreciation for tax purposes compared to straight-line depreciation for financial reporting.

Conversely, a deferred tax asset signifies that a company has paid more taxes or recognized more expenses for accounting purposes than allowed for tax purposes in the current period, leading to a future tax benefit. This can arise from items like warranty provisions, where the expense is recognized for accounting purposes when the obligation arises, but deductible for tax purposes only when paid. The realization of deferred tax assets is contingent on future taxable income against which these assets can be offset. If it's not probable that sufficient taxable income will be available, a valuation allowance must be recognized to reduce the deferred tax asset to its realizable value.

Hypothetical Example

Consider Tech Innovations Inc. (TII), a software company. In its financial statements, TII recognizes revenue from annual software subscriptions evenly over the 12-month subscription period. For tax purposes, however, the local tax authority requires TII to recognize the entire subscription revenue when the cash is received upfront.

Let's assume:

  • TII receives $1,200,000 in upfront cash for 12-month subscriptions on December 31, 2024.
  • For financial reporting (accounting period ending December 31, 2024), TII recognizes only $100,000 (1/12th) of this revenue, with the remaining $1,100,000 as deferred revenue (a liability).
  • For tax purposes, the full $1,200,000 is recognized as revenue in 2024.
  • The enacted future tax rate is 25%.

In this scenario, TII's taxable income in 2024 will be higher than its accounting income due to the timing difference in revenue recognition. This creates a deferred tax liability.

Calculation:

  • Temporary difference = Accounting Revenue ($100,000) - Tax Revenue ($1,200,000) = -$1,100,000 (meaning accounting income is lower by $1,100,000 compared to tax income, which implies more tax has been paid than recognized for accounting, leading to a future tax obligation).
  • More precisely, the deferred revenue on the balance sheet for accounting is $1,100,000, but its tax base is $0 (because it's already been taxed).
  • Deferred Tax Liability = (Carrying Amount of Deferred Revenue - Tax Base of Deferred Revenue) x Tax Rate
  • Deferred Tax Liability = ($1,100,000 - $0) x 25% = $275,000

This $275,000 is recorded as a deferred tax liability on TII's December 31, 2024, balance sheet. As TII recognizes the remaining $1,100,000 in accounting revenue over the subsequent months, this deferred tax liability will reverse, reducing TII's future tax payments relative to its future accounting income.

Practical Applications

Deferred tax appears frequently in various financial contexts, impacting how investors, analysts, and regulators assess a company's financial health.

  • Financial Analysis: Analysts closely examine deferred tax balances to understand the sustainability of a company's effective tax rate and its future cash tax obligations. Significant deferred tax liabilities might indicate a history of aggressive tax depreciation or other items that pulled tax payments forward, while large deferred tax assets could signal future tax savings, provided sufficient taxable income is generated.
  • Mergers and Acquisitions (M&A): During M&A transactions, the deferred tax assets and liabilities of target companies are meticulously evaluated as they can significantly impact the deal's valuation and post-acquisition tax strategies. For instance, a target company with substantial net operating loss (NOL) carryforwards (a common source of deferred tax assets) could be attractive for its potential to reduce the acquirer's future tax liabilities.
  • Regulatory Scrutiny: Regulatory bodies, such as the IRS in the United States, provide extensive guidance on corporate tax matters. IRS Publication 542, for example, details tax laws for domestic corporations, which directly influence how companies calculate their current and deferred tax positions.2
  • Global Tax Policy: International tax reforms, such as the global deal on a minimum corporate tax spearheaded by the OECD, have significant implications for deferred tax accounting, particularly for multinational corporations.1 These changes often necessitate re-evaluations and adjustments to existing deferred tax balances to align with new global tax frameworks.

Limitations and Criticisms

While deferred tax accounting aims to provide a comprehensive view of a company's tax position, it is not without limitations and has faced criticisms. One major critique is the inherent subjectivity involved in estimating future tax rates and the likelihood of realizing deferred tax assets. The need for a valuation allowance against deferred tax assets, when their realization is not probable, introduces a significant element of management judgment, which can impact reported earnings.

Furthermore, deferred tax balances are based on timing differences that will reverse in the future. However, the exact timing and the applicable tax rates at the time of reversal can be uncertain. Changes in tax laws or a company's profitability can significantly alter the value and realizability of these deferred amounts, potentially leading to large non-cash adjustments in the income statement. For example, a reduction in corporate tax rates, as seen with the Tax Cuts and Jobs Act in the U.S., led many companies to re-measure their deferred tax assets and liabilities, often resulting in significant one-time impacts on earnings.

The complexity of deferred tax calculations, especially for multinational corporations operating under various tax jurisdictions and diverse accounting standards (e.g., U.S. GAAP vs. IFRS), can also make it challenging for external users of financial statements to fully grasp the nuances. This complexity can sometimes obscure rather than clarify a company's true financial performance from a tax perspective.

Deferred Tax vs. Current Tax

The distinction between deferred tax and current tax is fundamental to financial accounting.

  • Current Tax: This refers to the amount of income tax payable (or refundable) to the tax authorities for the current period, based on the current period's taxable income. It represents the immediate tax obligation or benefit that results from the company's operations as per tax laws.
  • Deferred Tax: This relates to the future tax effects of transactions or events that have already been recorded in a company's financial statements but whose tax consequences are yet to materialize. It arises from temporary differences between the financial reporting of revenues and expenses and their treatment for tax purposes. A deferred tax asset represents a future tax reduction, while a deferred tax liability represents a future tax obligation.

The confusion between the two often stems from the fact that both contribute to a company's total tax expense reported in its financial statements. However, current tax is a cash-based or immediately payable amount, while deferred tax is a non-cash adjustment that reconciles the accounting profit with the tax profit over time, ensuring that the effects of all transactions are eventually recognized for tax purposes.

FAQs

Q: Why do companies have deferred tax?
A: Companies have deferred tax because there are often differences in the timing of how income and expenses are recognized for financial reporting (e.g., under GAAP or IFRS) and how they are recognized for tax purposes. These timing disparities lead to temporary differences that will eventually reverse, creating either a future tax payment (deferred tax liability) or a future tax saving (deferred tax asset).

Q: Is deferred tax a good or bad thing for a company?
A: Deferred tax itself is neither inherently good nor bad; it's an accounting construct to properly match income and expenses with their tax consequences over time. A deferred tax asset can be beneficial as it represents future tax savings, while a deferred tax liability indicates future tax payments. The interpretation depends on the underlying reasons for the deferred tax and a company's overall financial health and future prospects.

Q: How does deferred tax affect a company's cash flow?
A: Deferred tax is a non-cash item on the income statement, meaning it does not directly impact a company's current cash flow. However, the reversal of deferred tax balances in future periods will affect actual cash tax payments. For instance, the realization of a deferred tax asset will reduce cash taxes paid in the future, while a deferred tax liability reversing will increase them.

Q: What is the significance of the "future enacted tax rate" in deferred tax calculation?
A: The "future enacted tax rate" is crucial because deferred tax balances represent future tax effects. Accounting standards require companies to use the tax rates that are enacted or substantively enacted at the reporting date and expected to be in effect when the temporary differences reverse. This ensures that the deferred tax amounts are measured based on the most current and authoritative tax legislation.