Unlocking the Mystery of Deferred Income Tax

A deferred income tax is a liability recorded on a company’s balance sheet due to the differences in income recognition between tax regulations and the company’s accounting standards. This means that a company’s payable income tax may not equate to the total tax expense reported in its financial statements.

The total tax expense for a specific fiscal year might differ from the tax liability owed to tax authorities like the Internal Revenue Service (IRS) because the company’s payment is deferred based on these distinct accounting rules.

Key Takeouts

Deferred income tax arises due to income recognition differences between tax laws (e.g., IRS rules) and accounting practices (e.g., GAAP).
It shows up as a liability on the balance sheet.
One common cause is the difference in depreciation methods between IRS rules and GAAP guidelines.
Depending on the nature of the deferral, it can be classified as either a current or long-term liability.

Understanding Deferred Income Tax

In the U.S., generally accepted accounting principles (GAAP) guide how companies handle their financial accounting. GAAP requires the calculation and disclosure of economic events in a certain structured manner, and this includes the calculation of income tax expense. On the other hand, the IRS has its specific tax codes which often lead to different income tax computations.

These discrepancies between IRS rules and GAAP guidelines typically cause a divergence in net income calculations and subsequently, the income taxes due on this income. Deferred income tax liability results from the difference between the reported income tax expense on income statements and the actual income tax payable.

There might be situations where taxable income resulting in income tax payable as per the tax return is higher than the income tax expense listed on financial statements. Over time, if no further reconciling events occur, the deferred income tax balance would reconcile back to zero. In scenarios without the deferred income tax liability account, a deferred income tax asset could be created, indicating expected future economic benefits due to initially overpaid taxes.

Examples of Deferred Income

One common scenario that creates deferred income tax liabilities involves different depreciation methods. While GAAP allows businesses flexible options in choosing their depreciation methods, the IRS enforces a specific structure that varies from all GAAP-sanctioned methods. Due to these variances, the amount of depreciation on financial statements often differs from what’s seen on tax returns. This discrepancy shifts over the asset’s lifecycle but balances out in the long run when total depreciation aligns, resolving the deferred tax liability.

Why Is Deferred Income Tax an Asset?

Deferred income tax has been characterized predominantly as a liability because it signifies money typical owed in future periods. However, if the situation arises where a company has overpaid on its taxes, this would be a deferred tax asset, appearing on the balance sheet as a non-current asset.

Simplifying Deferred Income Tax

Simply put, deferred income tax represents taxes owed in the future, driven by differences between how companies and tax authorities recognize revenue. Deferred tax reconciles these differences, maintaining financial report accuracy and regulatory compliance.

Current Tax vs. Deferred Tax

Current tax refers to tax that is payable within the current fiscal period, whereas deferred tax accounts for tax intended to be settled in future periods, balancing current accounting methods and tax rules transitionally.

The Bottom Line

The income tax liabilities recognized by tax authorities often show disparities when compared to the total tax expenses reported by companies in their financial statements. This distinct difference is usually driven by varied income recognition standards between tax regulations and accounting principles, leading to deferred income tax—recognized as liability on balance sheets highlighting future payable taxes.

Related Terms: liability, income tax, fiscal year, IRS, tax expense, net income.

References

PricewaterhouseCoopers. “Demystifying deferred tax accounting”.
Univeristy of Minnesota. “15.3 Recognition of Deferred Income Taxes”.
Tax Foundation. “Three Differences Between Tax and Book Accounting that Legislators Need to Know”.
Internal Revenue Service “Topic No. 704, Depreciation”.

Get ready to put your knowledge to the test with this intriguing quiz!

--- primaryColor: 'rgb(121, 82, 179)' secondaryColor: '#DDDDDD' textColor: black shuffle_questions: true --- ## What is deferred income tax? - [ ] Tax that is currently due and payable - [x] A tax liability or asset that is recorded on the balance sheet resulting from temporary timing differences - [ ] A permanent change in the tax rate - [ ] A tax exemption for specific industries ## Which financial statement reports deferred income tax? - [ ] Income Statement - [x] Balance Sheet - [ ] Cash Flow Statement - [ ] Statement of Retained Earnings ## Deferred income tax liability occurs when: - [x] Tax expense reported in the income statement is higher than tax payable to the tax authorities - [ ] Tax expense reported in the income statement is lower than tax payable to the tax authorities - [ ] There is an increase in revenue - [ ] Dividend payments are higher ## Deferred income tax asset typically results from: - [x] Carry-forward of losses or tax deductions - [ ] Earning above the expected income - [ ] Overestimation of the current tax liabilities - [ ] Dividend distributions ## Temporary timing differences that cause deferred income tax include: - [ ] Changes in interest rates - [ ] Fluctuations in stock prices - [x] Differences in depreciation methods for tax and accounting purposes - [ ] Variance analysis in performance metrics ## The purpose of recognizing deferred income tax is to: - [ ] Simplify tax reporting - [ ] Report higher earnings - [ ] Avoid tax payments - [x] Reflect future tax consequences of current transactions ## Which of the following can give rise to a deferred income tax asset? - [ ] Immediate expense of a prepaid amount - [x] Revenue that is recognized in the accounting period but taxable in a future period - [ ] An unrecognized pension liability - [ ] Operating with a tax exemption ## How can deferred income tax affect a company's future financial statement? - [ ] It equalizes the tax expense over several periods to reduce variations - [ ] It eliminates tax liabilities altogether - [x] It impacts future tax payments when temporary difference reverses - [ ] It sidesteps the tax audit ## An example of a deferred tax liability is: - [ ] Prepaid insurance - [ ] Future retirement benefits - [x] Accelerated depreciation for tax purposes - [ ] Reserve for contingent liabilities ## Deferred income tax adjustments are commonly due to: - [ ] Changes in market demand - [ ] Company's international strategies - [x] Variances between amounts deductible for depreciation - [ ] Change in marketing strategy