Definition
Deferred Income Tax is a liability that arises due to differences in income recognition between tax laws and a company’s accounting methods. In detail, it is the tax payable in the future on incomes that have been already recognized in the books of accounts but are yet to be recognized according to tax laws. The aim is to account for the timing difference that arises when tax obligations are delayed.
Key Takeaways
- Deferred Income Tax is a liability that occurs when the tax payable is less than the tax that has been calculated on the company’s financial statements. It’s a future tax obligation due to temporary differences in book value and tax value of assets and liabilities.
- There are two main categories of Deferred Income Tax: Temporary Differences and Permanent Differences. Temporary differences anticipate future obligations or benefits, while permanent differences do not affect taxable income in future years.
- Deferred Income Tax can serve as a type of financial cushion for a company, spreading the impact of a tax liability over a longer period of time. However, as it’s still a liability, it can affect the company’s financial stability if not properly managed.
Importance
Deferred Income Tax is a vital term in finance as it denotes the amount of taxes that a company has postponed to future reporting periods. This typically happens due to differences in the timing of income and expense recognition between tax books and company ledgers.
For instance, a company may have already recognized some revenue in its financial accounting books but not on its tax return. This mismatch is why companies create a deferred tax liability or asset.
Understanding deferred income taxes allows investors and stakeholders to make informed decisions about a company’s future tax obligations, which can significantly impact profitability. Therefore, it’s essential to comprehensively analyze an entity’s future responsibilities and the potential impact on its future cash flow.
Explanation
Deferred Income Tax is primarily used to reconcile the differences between the tax obligations calculated on a company’s financial statements and the taxes a company must pay according to statutory tax rules. Essentially, it serves to balance between accounting principles and tax regulations.
These accounting discrepancies generally occur due to the differing methods used by tax legislation and the Generally Accepted Accounting Principles (GAAP). It helps to manage the variation or timing differences that might arise from the recognition of income and expenses for tax and accounting purposes. One of the main purposes of deferred income tax is to mitigate the effect of temporary differences that could affect a company’s financial health in the future.
These temporary differences can arise due to distinct deductions and income recognition structures in accounting standards and tax laws. By using deferred tax, companies are also able to reduce the possibilities of overstatement or understatement of their fiscal obligations, therefore providing a more accurate reflection of their financial position.
This assists in financial planning and investment decisions, giving a complete picture of a company’s future liabilities.
Examples of Deferred Income Tax
Apple Inc: The tech giant Apple, for instance, reported considerable deferred income tax in its quarterly and annual reports. The deferred taxes mostly arise from differences in depreciation methods used by the IRS and what is reported on their financial statements. This goes a long way in managing the company’s tax obligations and ensuring that it obeys related regulations.
Coca Cola Company: In its financial statement, Coca Cola Company also reports deferred income tax. This often results from the tax effects of temporary differences between their accounting and tax carrying amounts of assets and liabilities. The company strategically uses this to minimize current tax expenses and save for future taxes.
General Electric: The multinational conglomerate, General Electric, offers another real-world example of deferred income tax. Due to differences between the financial and tax reporting related to the treatment of expenses like depreciation, incentives, and provisions, the company usually has substantial deferred tax liabilities or assets. This allows GE to manage its tax expenses over a period of time.
Deferred Income Tax FAQ
What is a Deferred Income Tax?
Deferred Income Tax refers to a liability recorded in the financial statements of a company that owes to the differences in income recognition between tax laws (IRS) and accounting methods (GAAP). It occurs because the income tax expense is recognized before (or after) it is paid.
What Causes Deferred Income Tax?
Differences between the way that a company calculates taxable income and the methods used to determine income reported in financial statement leads to Deferred Income Tax. This includes differences in depreciation methods, revenue recognition, and expense recognition.
Is Deferred Tax a Current Liability?
Deferred Tax Liability can both be a current and long-term liability. Current deferred tax liability refers to a deferred tax liability expected to be paid off within 12 months. Long-term deferred tax liability, on the other hand, refers to a liability that will not be paid off within 12 months.
What is the Difference between Deferred Tax Asset and Deferred Tax Liability?
A Deferred Tax Asset indicates that a company has overpaid tax or paid in advance on its Balance Sheet. It is an asset to the company. A Deferred Tax Liability implies a company has underpaid its taxes and will need to pay more tax in the future. It is a liability to the company.
How is Deferred Income Tax Calculated?
Deferred Income Tax is calculated by identifying the temporary differences between the book income (BI) (income before tax) and taxable income (TI). By subtracting the tax basis of an asset or liability from BI, we obtain TI. Then, by multiplying TI by the current tax rate get the Deferred Income Tax.
Related Entrepreneurship Terms
- Tax Liability
- Income Recognition
- Financial Reporting
- Balance Sheet
- Corporate Tax Rate
Sources for More Information
- Investopedia: A comprehensive online resource for definitions and explanations related to all aspects of finance and investing, including deferred income tax.
- Accounting Tools: A specialized resource offering detailed explanations and examples of accounting terms, principles, and procedures.
- Corporate Finance Institute: This site offers a range of financial analysis courses and resources, including detailed explanations of complex financial concepts such as deferred income tax.
- The Balance: The site provides expert-written articles on personal finance, career advice, and small business resources, including an explanation of deferred income tax.
