What is Deferred Income Tax? Explained

It simply refers to the tax that is overpaid or owed by the Company to the tax authorities. Deferred Income tax affects the tax outgo to the authorities for the financial year. If there is a deferred tax asset, the Company will have to pay less tax in the particular year, whereas, if there is a deferred tax liability, it will have to pay more tax.

GAAP requires income tax expense to be calculated on income before taxes on the income statement while the tax return calculates taxes due based on taxable income per the income tax return.

Deferred Income Tax

What are Deferred Income Taxes?

Standard accounting methods and tax accounting methods have different sets of rules. If you expect to receive a payment, you may have to pay taxes on it in the current period, but not when the payment is actually received. This type of timing difference creates a deferred tax situation.

When trying to understand deferred tax assets and liabilities, it’s important to keep in mind the difference between financial reporting and tax reporting. These two forms of accounting involve different rules and calculations, and these differences can result in both deferred tax assets and deferred tax liabilities.

Deferred income taxes are taxes that a company will eventually pay on its taxable income, but which are not yet due for payment. The difference in the amount of tax reported and paid is caused by differences in the calculation of taxes in the local tax regulations and in the accounting framework that a company uses. Examples of major accounting frameworks are Generally Accepted Accounting Principles and International Financial Reporting Standards.

Any taxes that are payable under the relevant accounting framework, but which are not yet payable under local tax regulations are recorded as a tax liability on a company’s balance sheet until such time as they are paid.

The tax liability is frequently recorded as a long-term liability in the balance sheet since there is usually no expectation of paying it within the next 12 months. This means that the deferred income taxes line item generally does not impact short-term liquidity ratios.

Understanding Deferred Income Tax

Understanding Deferred Income Tax

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. 

A deferred income tax liability results from the difference between the income tax expense reported on the income statement and the income tax payable.

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.

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 $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.

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