Definition
Deferred tax refers to a tax liability or asset that results from temporary differences between the book value of assets and liabilities and their value for tax purposes. It comes from differences in revenue recognition, expense recognition, and net operating losses between book and tax accounting that will eventually reverse. Essentially, it is income tax payable or recoverable in the future relating to transactions that have already occurred.
Key Takeaways
- Deferred tax is an accounting concept that deals with the timing difference between when transactions are recognized by accounting systems and when they are recognized by tax laws. It is essentially a potential tax liability or asset which will come due at a future date.
- There are two types of Deferred tax, Deferred Tax Liability and Deferred Tax Asset. Deferred Tax Liability arises when taxable income is smaller than the accounting income, while Deferred Tax Asset arises when taxable income is greater than the accounting income. The difference results from temporary differences that are expected to reverse in the future.
- Proper understanding and management of deferred taxes is crucial for a business, as it can impact a company’s financial analysis, tax filing, corporate planning and more. It is an important aspect to understand for investors as it indicates future tax obligation or benefit.
Importance
Deferred tax is a crucial concept in finance and accounting as it caters to the differences that occur between tax regulations and accounting methods. The importance of this term lies in its ability to reconcile these discrepancies and provide a more accurate representation of a company’s financial health.
Deferred taxes result from situations where the tax income is recognized in the books before it’s recognized on the tax return, or vice versa. It encompasses deferred tax assets and liabilities, and plays a significant role in financial planning and management, corporate transparency, and ensuring compliance with tax laws.
Compliance with Generally Accepted Accounting Principles (GAAP) also necessitates the calculation and reporting of deferred taxes. Therefore, understanding deferred tax is essential for investors, tax authorities, and anyone analyzing a company’s financial statements.
Explanation
Deferred tax is primarily a result of the difference in timing between when transactions are recognized by different accounting practices – namely, the accrual method of accounting and the cash method of taxation. In financial reporting, the accrual accounting principle requires companies to recognize revenues and expenses when they are earned or incurred respectively, regardless of when the cash transaction takes place. However, in taxation, taxable income is usually recognized when cash is received or paid.
As a consequence of these differing principles, a company may end up paying more or less taxes in the short term, and will need to balance this out in later accounting periods. This is where the concept of deferred tax comes into play. Deferred tax can either be an asset or a liability for the company.
If a company has paid more Taxes based on tax accounting compared to what was recognized in its financial reporting, it can recognize the amount overpaid as a deferred tax asset. On the other hand, if a company has underpaid taxes, it can recognize the underpaid amount as a deferred tax liability. The purpose of a deferred tax is to correct the timing difference created by different accounting practices for the true picture of a company’s financial situation.
Ultimately, the whole point of recognizing deferred tax is to ensure that a company’s financial statements comply with the principle of matching revenues with expenses in the correct accounting period.
Examples of Deferred Tax
Corporate Investments: Many corporations make investments that allow for tax deferral, meaning they won’t be required to pay taxes on the amount immediately, but will instead pay it at a later date. If a corporation purchases an asset (such as equipment or real estate) but it depreciates over time, they can defer the tax on this depreciation until the asset is sold.
Retirement Plans: Individual retirement plans like a 401(k) or an Individual Retirement Account (IRA) are a very common example of a situation where deferred tax applies. The money that’s placed into these accounts is often pre-tax dollars. This means you don’t pay taxes when making the contribution, but you’ll pay income taxes upon withdrawal after reaching retirement age.
Company Mergers and Acquisitions: In M&A scenarios, deferred tax liabilities or assets often arise due to differences in how companies account for income and how the IRS does. For instance, if a company used faster depreciation for tax purposes than for accounting purposes, it will have created a deferred tax liability — a future tax obligation. This would need to be considered in the merger or acquisition process.Remember, deferred tax doesn’t eliminate the tax obligation; it only postpones it to a future period.
FAQs about Deferred Tax
What is Deferred Tax?
Deferred tax is an accounting term that refers to a situation where a business has a difference in income recognition between accounting records and tax records. It is a result of temporary differences between the company’s accounting and tax carrying values, the anticipated and enacted income tax rate, and any unused tax credits or loss carryforwards.
What is a Deferred Tax Asset?
A deferred tax asset is an item on the balance sheet that results from overpayment or advance payment of taxes. It is the opposite of a deferred tax liability. Both are used in accrual accounting to ensure the company adheres to the matching principle.
What is a Deferred Tax Liability?
A deferred tax liability represents an amount of taxes that a company will owe in the future. It is the tax impact of income that has been recognized in the financial statements, but not yet in the tax return.
How is Deferred Tax computed?
Deferred tax is calculated as the tax effect of the temporary differences existing as of the Balance Sheet date, between the book balance and tax balance of assets and liabilities. It is calculated at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled.
What is the relevance of Deferred Tax on a company’s financial health?
Deferred tax liabilities can represent future tax payments a company must make, which is a potential obligation. Hence, they are often viewed as debt. On the other hand, deferred tax assets are prepayments and can be seen as an amount that is recoverable in the future, which can offset future tax payments. This can affect the company’s profitability and cashflows.
Related Entrepreneurship Terms
- Income Tax Expense
- Tax Liability
- Balance Sheet
- Temporary Difference
- Asset Carryforward
Sources for More Information
- Investopedia: A comprehensive resource for investing education, personal finance, market analysis, and free trading simulators.
- Accounting Tools: Offers articles on a wide range of accounting, audit, and corporate finance topics.
- Corporate Finance Institute: It provides online courses and certifications for the finance industry.
- PwC: A global network of firms delivering world-class assurance, tax, and consulting services for businesses.
