What Is Deferred Income Tax?
A deferred income tax is a liability recorded on a balance sheet resulting from a difference in income recognition between tax laws and the company’s accounting methods. For this reason, the company’s payable income tax may not equate to the total tax expense reported.
The total tax expense for a specific fiscal year may be different from the tax liability owed to the Internal Revenue Service (IRS), as the company is postponing payment based on accounting rule differences.
- Deferred income tax is a result of the difference in income recognition between tax laws (i.e., the IRS) and accounting methods (i.e., GAAP).
- Deferred income tax shows up as a liability on the balance sheet.
- The difference in depreciation methods used by the IRS and GAAP is a common cause of deferred income tax.
- Deferred income tax can be classified as either a current or long-term liability.
Understanding Deferred Income Tax
In the U.S., generally accepted accounting principles (GAAP) guide financial accounting practices. GAAP accounting requires the calculation and disclosure of economic events in a specific manner. Income tax expense, which is a financial accounting record, is calculated using GAAP income.
In contrast, the IRS tax code specifies special rules on the treatment of events. The differences between IRS rules and GAAP guidelines result in different computations of net income, and subsequently, income taxes due on that income.
A deferred income tax liability results from the difference between the income tax expense reported on the income statement and the income tax payable.
Situations may arise where the income tax payable on a tax return is higher than the income tax expense on a financial statement. In time, if no other reconciling events happen, the deferred income tax account would net to $0.
However, without a deferred income tax liability account, a deferred income tax asset would be created. This account would represent the future economic benefit expected to be received because income taxes charged were in excess based on GAAP income.
Example of Deferred Income
A common situation that generates a deferred income tax liability is from differences in depreciation methods. GAAP guidelines allow businesses to choose between multiple depreciation practices. However, the IRS requires the use of a depreciation method that is different from all available GAAP methods.
For this reason, the amount of depreciation recorded on a financial statement is usually different from the calculations found on a company’s tax return. Over the life of an asset, the value of the depreciation in both areas changes. At the end of the life of the asset, no deferred tax liability exists, as the total depreciation between the two methods is equal.
Why Is Deferred Income Tax an Asset?
Deferred income tax is considered a liability rather than an asset as it is money owed rather than to be received. If a company had overpaid on taxes, it would be a deferred tax asset and appear on the balance sheet as a non-current asset.
What Is Deferred Income Tax in Simple Terms?
Deferred income tax is tax that must be paid in the future to account for differences in how companies recognize income and how tax authorities recognize income.
What Is the Difference Between Current Tax and Deferred Tax?
Current tax is tax payable, while deferred tax is intended to be paid in the future.
The Bottom Line
The income tax a company owes to tax authorities may not be the same as the total tax expense reported in its financial statement. This discrepancy can happen often and is caused by contrasting income recognition standards between tax and accounting laws. The upshot is deferred income tax, which is presented as a liability on balance sheets and represents tax that must be paid in the future.