Deferred Income Tax

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 liability, it will have to pay more tax.

Deferred Income Tax

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For eg:
Source: Deferred Income Tax (wallstreetmojo.com)

Causes of Deferred Income Tax Expense

deferred tax

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.

You can download this Deferred Income Tax Excel Template here – Deferred Income Tax Excel Template

1) Deferred Income Tax Asset

deferred tax assets

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

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 inventory 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

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.

This article has been a guide to what is Deferred Income Tax expense and its definition. Here we discuss deferred income tax along with its calculation, causes, and practical examples. You can learn more about financing from the following articles –

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