Deferred Income Tax Definition
Deferred income tax is a balance sheet item which can either be a liability or an asset as it is a difference resulting from recognition of income between the accounting records of the company and the tax law because of which the income tax payable by the company is not equal to the total expense of tax reported.
It simply refers to the tax that is overpaid or owed by the Company to the tax authorities. Deferred Income tax affects the tax outgo to the authorities for the financial year. If there is a deferred tax assetDeferred Tax AssetA deferred tax asset is an asset to the Company that usually arises when either the Company has overpaid taxes or paid advance tax. Such taxes are recorded as an asset on the balance sheet and are eventually paid back to the Company or deducted from future taxes.read more, the Company will have to pay less tax in the particular year, whereas, if there is a deferred tax liabilityDeferred Tax LiabilityDeferred tax liabilities arise to the company due to the timing difference between the accrual of the tax and the date when the company pays the taxes to the tax authorities. This is because taxes get due in one accounting period but are not paid in that period.read more, it will have to pay more tax.
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For eg:
Source: Deferred Income Tax (wallstreetmojo.com)
Causes of Deferred Income Tax Expense
Deferred tax is created due to the difference in the timing of book profitBook ProfitBook Profit is the profit amount that a business earns from its operations & activities but has not been realized yet. It is not tracked by analysts or stakeholders & its calculation is relevant only to evaluate a Company’s tax liability. read more and the taxable profit. Some items are deducted from the taxable profits, and others are not. Timing differences are of two types:
- Permanent Difference: The differences which cannot be reversed in the subsequent periods and may take a long time are permanent differences.
- Temporary Difference: The difference which can be reversed in the subsequent period and is generally created because the items are charged and taxed in different periods of time is the temporary difference.
Let us discuss the two types of Deferred Income Tax expense in detail.
1) Deferred Income Tax Asset
Deferred tax asset is created when the Company has already paid the tax. The benefit of deferred tax assets is that the Company will have less tax outgo in the future subsequent years.
Example
Consider an Electronics Company XYZ Inc., which gives a warranty on the goods and assumes that the warranty repairs cost will go around 5% of the total revenue. If the revenue for the period is $ 500,000, then the balance sheet of the Company to the shareholders and the tax department will be:
Balance Sheet for Shareholder’s
Balance Sheet for Tax Authorities
There is a tax difference of $ 6,250, which the Company has already paid but is not visible in the balance sheet. Thus, it will record a deferred tax asset of $ 6,250 for the period.
2) Deferred Income Tax Liability
Deferred tax liability is created when the Company underpays the tax, which it will have to pay in the near future. The liability is created not due to Company defaulting on its tax liabilities but due to timing mismatch or accounting provisionsAccounting ProvisionsThe provision in accounting refers to an amount or obligation set aside by the business for present and future commitments. Provisions are estimates of future related probable losses from past and present events calculated by following predefined regulatory guidelines by banks and financial institutions.read more, which causes less tax outgo than required by the Company.
Example
An Oil Company ABC Inc produces 10,000 barrels of oil at the cost of $ 15 per barrel in 1st year. But in the next year, the labor cost increased, and it produced the same amount of oil but with a cost of $ 20. The Company sold the oil at the end of year 2 but used different accounting treatment for financial purposes and tax purposes. It recorded the cost as $ 150,000 FIFO inventoryFIFO InventoryUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost.read more for the financial balance sheet where it recorded the cost as $ 200,000 for tax purposes LIFO inventoryLIFO InventoryLIFO (Last In First Out) is one accounting method for inventory valuation on the balance sheet. LIFO accounting means inventory acquired at last would be used up or sold first.read more. It created a temporary difference of $ 50,000, and if the tax rate is 30% would create a tax liability of $ 15,000.
Important Notes – Deferred Income Tax
- Deferred tax impacts the future cash flows for the CompanyCash Flows For The CompanyCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more – while deferred tax assets lower the cash outflow, deferred tax liability increases the cash outflow for the Company in the future
- Change in deferred taxDeferred TaxDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid.read more balances should be analyzed to understand the future course – if the difference is going to rise or there will be a reversal in the trend of the deferred taxes
- Deferred taxes are prone to the type of business the Company is in. If it’s a capital-intensive business and Company purchases new assets, it will have an increasing deferred tax liability because of accelerated depreciationAccelerated DepreciationAccelerated depreciation is a way of depreciating assets at a faster rate than the straight-line method, resulting in higher depreciation expenses in the early years of the asset's useful life than in the later years. The assumption that assets are more productive in the early years than in later years is the main motivation for using this method. read more of the assets
- Analysts should look for changes in deferred taxes by reading the footnotes to the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, which could include information about the warranty, bad debts, write-downs, policy on capitalizing or depreciating assets, policy on amortizing financial assets, revenue recognition policy, etc.
Conclusion
Deferred tax is a balance sheet line item which is recorded because the Company owes or pay more tax to the authorities. The deferred tax represents the negative or positive amounts of tax owed by the Company. Deferred income taxes impact the future cash flow of the Company, i.e., if its an asset, the cash outflow will be less, and if it’s a liability, the future cash outflow will be more.
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