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.
Deferred Income Tax Definition
Deferred Income Tax (asset or a liability on the balance sheet) which 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 asset, the Company will have to pay less tax in the particular year, whereas, if there is a deferred tax liability it will have to pay more tax.
Causes of Deferred Income Tax Expense
Deferred tax is created due to the difference in the timing of book profit and the taxable profit. There are some items which 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 longer 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.
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Example of Deferred Income Tax Asset
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 to the tax department will be as below:
Balance Sheet for Shareholder’s
Balance Sheet for Tax Authorities
Clearly, 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 provisions which causes less tax outgo than required by the Company.
Example of Deferred Tax Liability
An Oil Company ABC Inc produces 10,000 barrels of oil at a 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 for tax purposes. It recorded the cost as $ 150,000 (using FIFO – first in first out) for financial balance sheet where it recorded the cost as $ 200,000 for tax purposes (using LIFO – last in first out). This 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 Company – while deferred tax assets lower the cash outflow, deferred tax liability increases the cash outflow for the Company in the future
- Change in deferred tax 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 depreciation of the assets
- Analysts should look for changes in deferred taxes by reading the footnotes to the financial statements 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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