What is Deferred Tax
- by:
- Nick H
Key Points
Deferred tax arises from timing differences between accounting rules and tax laws
There are two main types: deferred tax assets, which represent future tax savings due to overpaid taxes, and deferred tax liabilities
Deferred tax assets and liabilities are reported on the balance sheet and changes in these balances affect the company’s income
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Taxes play a major role in how companies report their earnings and manage their financial health. One important but often misunderstood aspect of corporate accounting is deferred tax. Deferred tax is a concept that sits at the intersection of accounting and tax law. It refers to a tax obligation or benefit that is postponed to a future period due to timing differences between the way transactions are recognized in accounting records and when they are reported for tax purposes.
Deferred tax can be a tricky concept for new investors and even business professionals to grasp, but it is essential for anyone who wants to fully understand a company’s financial statements. Knowing how deferred tax works can provide insight into a company’s real profitability and future tax obligations.
The Basic Idea Behind Deferred Tax
The main reason deferred tax exists is because the rules for recognizing revenue and expenses in financial accounting are different from the rules used for tax reporting. Financial accounting is typically guided by standards like Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), while tax accounting follows specific laws set by tax authorities.
These differences mean that sometimes a company will record income or expenses in its financial statements before or after it records them for tax purposes. This creates a timing gap between what is reported to shareholders and what is reported to tax authorities, and deferred tax is the accounting tool used to keep track of these differences.
Types of Deferred Tax: Deferred Tax Asset and Deferred Tax Liability
There are two main types of deferred tax that appear on a company’s balance sheet: deferred tax assets and deferred tax liabilities.
A deferred tax asset represents a situation where a company has paid more taxes to the tax authorities than it has recognized as an expense in its financial statements. This often occurs when certain expenses are recognized earlier for tax purposes but later for accounting purposes. Deferred tax assets signal that the company should pay less tax in the future because it has already overpaid relative to its accounting income.
A deferred tax liability is the opposite. It arises when a company has recognized more expense in its financial statements than it has deducted for tax purposes, or it has recognized income for accounting purposes before it is recognized for tax purposes. This means the company will likely owe more tax in the future because it has underpaid relative to its accounting income.
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Common Causes of Deferred Tax
Deferred tax most commonly arises from differences in the timing of revenue and expense recognition. Here are a few examples:
Depreciation Methods: Companies often use different depreciation schedules for accounting and tax purposes. For example, they might use straight-line depreciation for their financial statements but accelerated depreciation for tax returns. This creates differences in reported profits and taxes owed over time.
Bad Debt Provisions: For accounting purposes, companies may estimate and record a provision for doubtful debts. Tax authorities, however, might only allow a deduction when a debt is actually written off.
Warranty Expenses: Companies may record an estimated expense for future warranty claims in their financial statements, but tax authorities might only allow the deduction when the actual claim is paid.
These differences result in temporary discrepancies between the accounting income and taxable income, leading to the creation of deferred tax assets or liabilities.
How Deferred Tax is Reported
Deferred tax assets and liabilities appear on the balance sheet, usually under non-current assets and liabilities. The changes in these balances from year to year also affect the company’s income statement, showing up as deferred tax expense or benefit. This ensures the tax expense reported in the income statement better matches the actual economic activity during the period, rather than just reflecting what was paid to the tax authorities.
Why Deferred Tax Matters to Investors and Analysts
Deferred tax can have a significant impact on a company’s reported profits and future cash flows. By understanding deferred tax, investors and analysts can gain a more accurate picture of a company’s financial health and the sustainability of its earnings. For example, a large deferred tax liability suggests the company will pay higher taxes in the future, while a deferred tax asset may indicate future tax savings.
It is also important for evaluating the quality of earnings. Some companies may have consistent deferred tax adjustments that smooth out their net income, making profits look more stable than they really are.
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Deferred Tax in Financial Analysis
When analyzing a company, investors should look at the notes to the financial statements to understand the main reasons for deferred tax balances. This can provide clues about the company’s accounting policies and potential risks related to changes in tax laws or business conditions.
Deferred tax is an essential topic in accounting and investing. It arises from timing differences between accounting rules and tax laws, resulting in either deferred tax assets or liabilities. Understanding deferred tax helps investors and analysts assess the real profitability of a business and anticipate future tax obligations or benefits. By looking beyond the headline numbers, anyone can gain a deeper understanding of how companies manage their tax positions and what it means for long-term value.
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