What is Deferred Tax?
Deferred Tax is the effect which arises in the company because of the timing differences between the date when taxes are paid to tax authorities actually by the company and the accrual of such tax i.e., differences of taxes arising as taxes due in one of the accounting period are either not paid or overpaid in that period.
The term “Deferred Tax Expense” refers to the income tax effect on a balance sheet arising out of difference taxable income calculated based on the company’s accounting method and the accounting income calculated based on tax laws. Further, it can also be termed as the income tax effect due to timing differences – temporary or permanent, which is taxes that are deferred.
It is the reason why the total tax expense reported in the income statement is usually not equal to the company’s payable income tax according to the tax laws.
Types of Deferred Tax
Based on the timing difference, it can be broadly categorized into two types – 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 and deferred tax liability. Now, let us have a look at each of them separately:
#1 – Deferred Tax Asset (DTA)
DTA comes into effect when the company has either paid taxes in advance or has overpaid taxes. In other words, when a company books profitBooks 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 lower than the taxable profit, then it ends up paying more taxes, which is then reflected in the balance sheet as a deferred tax asset. It is carried on the balance sheet of a company so that it can be used in the future to reduce the taxable income.
#2 – Deferred Tax Liability (DTL)
DTL comes into effect due to tax that is payable for the current period but has not been paid yet. In other words, when a company books profit higher than the taxable profit, then it pays lower than reported tax and in the process results in such liability. It is the future tax payment that the company is expected to make in order to appropriate tax authorities.
Deferred Tax Formula
The formula is calculated by computing the difference between the tax payable according to income tax laws and the tax reported as per the company’s accounting method Accounting MethodAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.read more. Mathematically, it is represented as,
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For eg:
Source: Deferred Tax (wallstreetmojo.com)
Examples of Deferred Tax Expense
Let’s see some simple to advanced examples to understand it better.
Example #1
Let us take an example where the company has purchased a new mobile worth $10,000 with a useful life of 10 years. The company uses the straight-line method for both company reporting and tax reporting. However, the company depreciations the asset at 15%, but the income tax department prescribes a 20% depreciation rate for the asset. Determine the DTA created because of the difference in rate. Please note that the company reported EBITDA of $5,000, an interest expense of $800, and an effective tax rateEffective Tax RateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more is 35%.
Solution:
Therefore, the calculation is as follows,
= ($5,000 – 15% * $10,000 – $800) * 35% – ($5,000 – 20% * $10,000 – $800) * 35%
= $945 – $770
DTA = $175
Therefore, the reported DTA at the end of first year is $175.
Example #2
Let us take the example of equipment that has a useful life of four years and is worth $2,000. The company books depreciation as per the straight-line methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more, while it uses the double-declining methodDouble-declining MethodThe Double Declining Balance Method is one of the accelerated methods used for calculating the depreciation amount to be charged in the company's income statement. It is determined by multiplying the book value of the asset by the straight-line method's rate of depreciation and 2read more for tax reporting purposes. Determine the cumulative DTL reported in the balance at the end of year 1, year 2, year 3 and year 4 if the reported EBITDA and interest expense are $2,500 and $200 in each of the years and the applicable tax rate is 35%.
Solution:
Therefore, the calculation for year 1 is as follows,
DTL for Year 1 = $175
Similarly, we can do the calculation of deferred tax liability for year 2 to year 4.
Let us draw a table to capture the effect of deferred tax expense.
Please refer given excel template above for detail calculation.
So, we can see that in this case, there is DTL being created in year 1 as the company has booked a higher profit than the taxable profit. However, in year 2, the reported tax is equal to tax payable and hence no income tax effect. From year 3 onwards, the reported tax is lower than tax payable, and hence the DTLs in the balance start to deplete.
The cumulative tax liabilities, which are reported in the balance sheet, stood at $175, $175, $88, and $0 at the end of year 1, year 2, year 3, and year 4, respectively.
Conclusion
The deferred tax expense can be very important information for both existing investors and prospective investors as they intend to crosscheck the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more of a company with its income statement to verify if there is any tax payable for the company during the given period.
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