Most business owners would agree that understanding deferred taxes can be confusing.
But properly accounting for deferred tax assets and liabilities is critical for accurate financial reporting. In this article, you'll get a clear, simplified explanation of deferred taxes - perfect for small business owners and entrepreneurs trying to wrap their heads around this complex topic.
We'll cover what exactly deferred taxes are, walk through deferred tax asset and liability examples, explain how to calculate and record deferred taxes, and provide key takeaways for managing deferred tax processes in your books.
Introduction to Deferred Tax
Deferred tax refers to income taxes that are due in future periods based on differences between the financial reporting and tax bases of assets and liabilities. Understanding deferred tax is important for companies to accurately represent their financial position.
What is Deferred Tax?
Deferred tax arises when there are temporary differences between the carrying value of assets and liabilities on a company's financial statements, and their tax bases. For example:
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A company may report higher net income on its financial statements due to the use of accelerated depreciation methods for tax purposes. This temporary difference leads to a deferred tax liability, as tax will be owed when the assets are fully depreciated.
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Expenses may be deductible for tax purposes in different periods than when they are recognized for financial reporting. This leads to deferred tax assets, as the amount of tax refundable in future periods increases.
Deferred taxes represent future tax consequences - they do not require immediate tax payments or refunds. Proper deferred tax accounting separates tax and financial reporting timing differences to show investors the company's true financial position.
Why Manage Deferred Taxes?
Managing deferred taxes is important for several reasons:
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Accurately quantifying deferred tax assets and liabilities leads to better financial reporting. This helps investors understand a company's net income and future cash flow obligations.
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Changes in deferred taxes from year to year have a direct impact on a company's effective tax rate. Tracking deferred taxes facilitates tax planning and forecasting.
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Deferred tax assets and liabilities are calculated based on a company's expected future income and expenses. Monitoring them provides insight into management's outlook and assumptions.
In summary, properly accounting for deferred taxes provides transparency into temporary reporting differences between financial statements and tax returns. Companies that fail to do so may misrepresent financial performance and future tax liabilities to investors.
What are deferred tax assets and liabilities for dummies?
A deferred tax asset represents a reduction in future tax liability, while a deferred tax liability represents an increase in future tax liability. Here is a simplified explanation:
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Deferred tax assets - these arise when a business has overpaid taxes or paid taxes in advance, resulting in an asset on the balance sheet. For example, if a business makes a loss one year and therefore pays no tax, it can carry that loss forward to offset taxes in future profitable years. The tax saving expected in future years is recorded as a deferred tax asset.
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Deferred tax liabilities - these arise when a business has underpaid taxes, resulting in a liability on the balance sheet. For example, if tax rules allow faster depreciation than accounting rules, taxable profits will be lower than accounting profits in early years, but the opposite happens later. The additional tax expected to be paid in future years is recorded as a deferred tax liability.
In summary, deferred tax assets represent future tax savings, while deferred tax liabilities represent additional future taxes. They exist because tax rules and accounting rules differ in the timing of when income and expenses are recognized. Businesses record these timing differences in their balance sheet to match tax expenses to the years the related income or expenses are reported.
What is the effect of deferred tax assets and liabilities?
Deferred tax assets and liabilities can have a significant impact on a company's cash flow and financial statements. Here are some key effects:
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Cash flow impact: An increase in deferred tax liabilities or a decrease in deferred tax assets results in higher tax payments in future years, which is a source of cash outflow. Conversely, a decrease in deferred tax liabilities or an increase in deferred tax assets reduces future tax payments, which is a source of cash inflow.
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Balance sheet impact: Deferred tax assets and liabilities are balance sheet items that represent future tax consequences of temporary differences between accounting and taxable income. An increase in deferred tax liability increases non-current liabilities on the balance sheet. An increase in deferred tax assets increases non-current assets.
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Income statement impact: Changes in deferred tax assets and liabilities from year to year result in deferred tax expense or benefit on the income statement. This affects the company's net income. For example, an increase in net deferred tax liabilities causes higher deferred tax expense, lowering net income.
In summary, deferred taxes can significantly impact a company's cash flow, balance sheet, and income statement. Proper measurement and reporting of deferred tax items are important for accurate financial reporting and modeling of future tax obligations.
What are deferred tax assets recognized for?
Deferred tax assets are recognized to the extent that it is probable (more than 50%) that sufficient taxable profits will be available to realize the deductible temporary difference or carryforward of unused tax losses or tax credits.
In simpler terms, a deferred tax asset represents future tax savings that a business can utilize if it earns enough taxable income in the future. Some examples of when a deferred tax asset may arise:
- A business has tax losses that can be carried forward to offset future taxable profits
- A business makes provisions for expenses or allowances that are tax deductible in the future when they are actually incurred
- There are differences in depreciation methods used for accounting vs. tax purposes
- Expenses are recognized earlier for accounting purposes than tax purposes
For a deferred tax asset to be recognized on the balance sheet, management has to estimate whether it is probable (i.e. >50% chance) that the business will generate sufficient future taxable income to be able to utilize the deferred tax asset.
If management estimates that it is not probable that there will be enough future taxable income, then the deferred tax asset is not recognized. Instead, the estimated future tax benefit is recorded as an unrecognized deferred tax asset.
In summary, deferred tax assets represent future potential tax savings, but can only be recorded as assets if management expects the business will earn enough income in the future to be able to utilize those tax savings.
What does a deferred tax asset represent?
A deferred tax asset represents future tax deductions or future tax refunds. It arises when an entity has overpaid taxes or paid taxes early, resulting in tax amounts that can be deducted or refunded in future years.
Some common examples that create deferred tax assets include:
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Carrying forward net operating losses - If a business has tax losses in one year, they can carry those losses forward to offset profits and reduce taxes owed in future years. The amount they can deduct in the future is a deferred tax asset.
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Accrued expenses that have been deducted for financial reporting purposes but not yet for tax purposes - For example, bonuses accrued at year-end have reduced accounting profit but may not be deductible for tax purposes until the next year when bonuses are paid out. The future tax deduction is a deferred tax asset.
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Differences in depreciation methods - If a company uses accelerated depreciation for tax purposes and straight-line depreciation for financial reporting, depreciation expense will be lower for tax purposes in early years, resulting in future tax deductions and deferred tax assets.
The key aspect that creates a deferred tax asset is when a business has overpaid income taxes or paid them early relative to accounting profit. These overpayments can then be deducted from taxable income in future years.
Tracking deferred tax assets allows a business to properly record the future tax benefits it has accumulated. These assets can be used to reduce tax expenses in future years as the temporary differences reverse.
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The Fundamentals of Deferred Tax Assets and Liabilities
Deferred tax assets and liabilities arise due to temporary differences between accounting and taxable income. Understanding these concepts is key for accurate financial reporting.
Understanding Deferred Tax Assets
A deferred tax asset represents a reduction in future tax liability resulting from expenses or losses already recognized on the income statement that have not yet been deducted on the tax return. Common examples include:
- Accrued expenses that have been recorded but not yet paid
- Allowances for doubtful accounts and inventory obsolescence
- Net operating loss carryforwards
These generate a future tax deduction and thus a deferred tax asset, which appears as a non-current asset on the balance sheet.
Deferred Tax Asset Calculation
To calculate a deferred tax asset, first identify all temporary deductible differences between book and tax income. Then apply the enacted future tax rate to these cumulative differences to estimate the deferred tax benefit they will create. Additional considerations around valuation allowances may also apply.
Recognizing Deferred Tax Assets
Deferred tax assets are recognized when it is probable the deductible temporary differences will be realized as future tax deductions. Stringent guidelines around certainty of realization must be met, otherwise a valuation allowance must be recorded against the deferred tax assets.
Identifying Deferred Tax Liabilities
A deferred tax liability represents additional future taxes payable resulting from revenues or gains already recognized on the financial statements but not yet included on the tax return. Common examples include:
- Revenues recognized but not yet taxed due to installment sales
- Depreciation differences due to accelerated tax depreciation
- Undistributed foreign earnings
These will result in higher future taxable amounts and thus generate a deferred tax liability.
Deferred Tax Liability: Current or Non-Current
Deferred tax liabilities are generally classified as non-current liabilities on the balance sheet. However, deferred tax liabilities expected to be settled or realized within 12 months are instead classified as current. Proper classification provides insight into the timing of these future tax impacts.
Deferred Tax Liability Examples
Deferred tax liabilities arise when there are temporary differences between the carrying value of assets and liabilities for financial reporting purposes and the amounts used for taxation purposes. Some common examples that give rise to deferred tax liabilities include:
Case Study: Depreciation and Deferred Tax Liability
Consider a company that purchases new equipment for $100,000. For financial reporting purposes, the company uses straight-line depreciation over 10 years, meaning they record $10,000 of depreciation expense each year. However, for tax purposes they use accelerated depreciation, depreciating the asset faster.
In the early years when tax depreciation is greater than book depreciation, this creates a deferred tax liability on the balance sheet. The company is deducting more depreciation for tax purposes currently, meaning they are paying less in taxes now. This will reverse in later years when book depreciation is greater than tax depreciation.
The deferred tax liability represents additional future taxes that will need to be paid when the temporary differences reverse. In this case, they are getting a tax deduction now faster than the depreciation expense is being recorded for financial reporting.
Journal Entry for Deferred Tax Liability
When the temporary difference occurs that leads to deferred taxes, the journal entry would be as follows:
Debit: Income Tax Expense $X Credit: Deferred Tax Liability $X
This increases tax expense on the income statement and creates the deferred liability on the balance sheet.
Then in future years when the temporary differences begin to reverse, the journal entry would be:
Debit: Deferred Tax Liability $X
Credit: Income Tax Expense $X
This reduces the deferred liability as the company starts to pay more in taxes, and decreases tax expense on the income statement.
Tracking deferred taxes properly is important for accurate financial reporting under GAAP accounting rules. Companies should review their deferred tax assets and liabilities each reporting period.
Measuring and Reporting Deferred Taxes
This section explores best practices for quantifying deferred tax balances and properly presenting them in financial statements.
Deferred Tax Asset in Balance Sheet
A deferred tax asset represents a reduction in future tax liability and is reported on the balance sheet. To calculate a deferred tax asset, identify timing differences between book and tax income that will reverse in the future. For example, expenses that are deductible before they are recognized on the books will create future tax deductions and thus a deferred tax asset.
The deferred tax asset is calculated by multiplying the timing difference by the applicable future tax rate. It should be reported on the balance sheet as a non-current asset, separate from current assets. Proper disclosure in the footnotes is also needed, including a breakdown of the significant components of deferred taxes.
Deferred Tax Liability Journal Entry
A deferred tax liability represents an increase in future tax liability. It arises from timing differences such as revenues or gains that are taxed before they are recognized on the books.
To record a deferred tax liability, debit income tax expense on the income statement. Then credit the deferred tax liability account on the balance sheet. This increases the liability account to represent the obligation to pay more taxes in the future.
Here is an example journal entry:
Debit:
Income Tax Expense $100
Credit:
Deferred Tax Liability $100
The deferred tax liability account should be reported on the balance sheet as a non-current liability.
Deferred Tax Expense in Financial Statements
Deferred income tax expense is the change in the deferred tax asset or liability balance from one period to the next. It represents the tax effects of timing differences and is reported on the income statement.
To calculate it, compare the ending and beginning deferred tax asset/liability balances for the period. The change between those balances is the deferred tax expense/benefit for the period.
This expense/benefit adjusts the overall tax provision and affects net income. Proper disclosure in the footnotes should explain what comprises the deferred amounts and why they changed period over period. This provides transparency into how deferred taxes impact earnings.
Managing Uncertainty in Deferred Taxes
Changes in tax laws and future operating results can introduce uncertainty into deferred tax calculations, requiring judgment calls.
Monitor Tax Law Changes
Tax rate and law changes may require remeasurement of deferred tax balances. It's important for businesses to closely monitor any proposed or enacted tax law changes that could impact their deferred tax assets and liabilities. For example, a reduction in future tax rates could require a write-down of existing deferred tax assets. Staying on top of tax law developments can help avoid surprises.
Update Estimates Each Period
Assumptions made about the expected reversals of temporary differences or the realizability of deferred tax assets may need to be revisited each reporting period. Changes in a company's operations, profitability, or industry conditions could alter previous projections. Reviewing estimates around deferred taxes regularly and making appropriate adjustments helps ensure greater accuracy.
Document Key Judgments
Significant management judgments made regarding deferred taxes, such as assumptions of future profitability, should be clearly explained and documented. Detailed documentation showing the rationale behind deferred tax measurements and estimates facilitates easier review by auditors and financial statement users. Being transparent about judgment calls provides greater credibility.
Implementing Deferred Tax Processes
Deferred tax accounting can be complex, but having strong processes in place makes compliance easier. Here are some recommendations:
Data Collection Procedures
- Gather necessary data from tax provision software, fixed asset records, finance systems, and operational budgets to calculate deferred tax assets and liabilities.
- Document policies for data ownership, validation checks, and retention periods.
- Automate data collection where possible to ensure completeness and accuracy.
Review and Approval Controls
- Subject deferred tax calculations, supporting schedules, and disclosures to appropriate levels of review by tax accountants.
- Tax department personnel should verify reasonableness of estimates and compliance with reporting standards.
- Maintain review evidence such as sign-offs.
Ongoing Maintenance
- Update deferred tax models at least annually as assets, liabilities, tax rates change.
- Assess impact of new tax legislation on deferred balances.
- Review processes periodically to identify improvement opportunities in data, technology, controls.
Establishing strong deferred tax accounting processes requires cross-functional collaboration between finance, tax, and accounting teams. With reliable data, diligent reviews, and regular maintenance, organizations can accurately track and disclose deferred tax positions.
Conclusion and Key Takeaways
Deferred tax assets and liabilities arise from temporary differences between accounting and taxable income. Properly accounting for them requires coordination across the business to track differences and changes in tax laws. Some key takeaways include:
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Deferred tax assets represent future tax deductions, while deferred tax liabilities represent future taxable amounts. They impact the timing of tax payments.
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Identifying and tracking temporary differences that create deferred taxes is crucial for accurate financial reporting. This requires diligent analysis and monitoring.
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Tax laws change frequently. Keeping current on new regulations allows deferred taxes to be recorded properly. Financial projections should factor in tax law impacts.
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Strong processes and controls around deferred tax calculations reduce risk of errors. Analyses should be reviewed by multiple stakeholders.
In summary, properly accounting for deferred income taxes requires coordination across the business, diligent tracking of temporary differences, monitoring of tax laws and operating results, and robust processes and controls. Handling deferred taxes appropriately enables more accurate financial statements.
