Deferred Tax- Meaning, Expense, Examples, Calculation

Introduction

Deferred tax is a provision that companies make to account for the difference between the tax they owe based on financial accounting principles and the tax they would owe based on tax accounting principles. This difference arises because financial accounting principles and tax accounting principles are not always the same, and companies must pay taxes based on the latter. Deferred tax is called “deferred” because the company does not currently owe the tax, but rather will owe it in the future when the underlying transaction is realized. For example, if a company takes a deduction for depreciation on its financial statements but cannot claim that deduction for tax purposes until a later year, it will have a deferred tax liability. Conversely, if a company has an asset that it cannot deduct for financial accounting purposes but can deduct for tax purposes in a later year, it will have a deferred tax asset.

What is an Example of the Deferred Tax Liability?

A deferred tax liability is a tax that is due in the future because of a temporary difference between the book income and the taxable income of a company. For example, if a company uses different depreciation methods for financial and tax accounting, it may have a higher book income than taxable income in the current period, but a lower book income than taxable income in the future periods. This creates a deferred tax liability, which means the company will pay more taxes in the future.

One example of a deferred tax liability is given below:

A company has reported taxable income of $100,000 and book income of $90,000. The company’s tax rate is 21%. The company’s deferred tax liability would be $2,100 ((21% x $100,000) – (21% x $90,000)).

Types of Deferred Tax

There are two main types of deferred taxes: deferred tax assets and deferred tax liabilities.

1. Deferred Tax Assets (DTAs):
Deferred tax assets (DTAs) represent the future tax benefits that a company can claim against its future tax liability. DTAs arise when a company has an asset or a loss that it cannot currently claim as a deduction for tax purposes, but expects to be able to claim in the future. For example, if a company has an asset that it cannot currently depreciate for financial accounting purposes but can depreciate for tax purposes in the future, it will have a DTA.

2. Deferred Tax Liabilities (DTLs):
Deferred tax liabilities (DTLs) represent the future tax obligations that a company will have to pay in the future. DTLs arise when a company has an expense or income that it cannot currently deduct or include in its taxable income, but expects to be able to deduct or include in the future. For example, if a company has an expense that it cannot currently deduct for financial accounting purposes but can deduct for tax purposes in the future, it will have a DTL.

How is Deferred Tax Liability Calculated?

Deferred tax liability (DTL) is calculated by estimating the future tax obligation that a company will have to pay in the future. The calculation involves several steps:

1. Determine the temporary difference:
The first step in calculating a DTL is to determine the temporary difference, which is the difference between the financial accounting and tax accounting values of an asset or liability. This difference arises because financial accounting principles and tax accounting principles are not always the same. For example, if a company has an asset that it cannot currently depreciate for financial accounting purposes but can depreciate for tax purposes in the future, it will have a temporary difference.

2. Determine the tax rate:
The next step is to determine the applicable tax rate. This rate is typically the statutory tax rate in the jurisdiction where the company operates.

3. Calculate the DTL:
The DTL is calculated by multiplying the temporary difference by the tax rate. This calculation represents the future tax obligation that a company will have to pay when it realizes the underlying transaction. For example, if a company has a temporary difference of $10,00 and a tax rate of 30%, its DTL would be $3,000 ($10,00 x 30%).

4. Adjust for timing differences:
In some cases, there may be timing differences between when a company recognizes an expense or income for financial accounting purposes and when it recognizes it for tax purposes. These timing differences can affect the calculation of DTAs and DTLs. To adjust for timing differences, companies must use present value calculations to estimate the future tax benefit or obligation. This involves discounting future cash flows to their present value using an appropriate discount rate.

5. Update DTLs:
DTLs must be updated each period to reflect changes in circumstances that could affect their value. This includes changes in temporary differences, tax rates, and present value calculations due to changes in interest rates or other economic factors. Companies must also consider whether any of their DTAs have become DTLs or vice versa due to changes in circumstances.

Scenarios in which Deferred Tax is Recorded?

Deferred tax is recorded when there are temporary differences between the accounting and tax treatment of certain items. These differences can affect the taxable income and the book income of a company, creating a deferred tax asset or liability. Some common scenarios in which deferred tax is recorded are:

Unrealized revenues and expenses: If a company recognizes revenue or expense in one period for accounting purposes, but in a different period for tax purposes, it creates a deferred tax. For example, if a company uses the accrual method of accounting, it may record revenue when it is earned, but pay tax when it is received. This creates a deferred tax liability, as the company will owe more tax in the future when it receives the cash.
The difference in the depreciation calculation method: If a company uses different methods of depreciation for accounting and tax purposes, it creates a deferred tax. For example, if a company uses the straight-line method of depreciation for accounting purposes, but the accelerated method for tax purposes, it will have a higher book income than taxable income in the current period, but a lower book income than taxable income in the future periods. This creates a deferred tax liability, as the company will pay more tax in the future when the assets are fully depreciated.
Difference in Depreciation Percentage: If a company uses the same method of depreciation for accounting and tax purposes, but different rates or percentages, it creates a deferred tax. For example, if a company depreciates an asset at 10% per year for accounting purposes, but 15% per year for tax purposes, it will have a lower book income than taxable income in the current period, but a higher book income than taxable income in the future periods. This creates a deferred tax asset, as the company will pay less tax in the future when the depreciation expense is lower.
Gross loss: If a company has a gross loss for accounting purposes, but a taxable income for tax purposes, it creates a deferred tax. For example, if a company has a loss from its operations, but a gain from the sale of an asset, it may have a negative book income, but a positive taxable income. This creates a deferred tax asset, as the company will pay less tax in the future when it can use the loss to offset its income.

Is Deferred Tax Liability Good or Bad ?

Deferred tax liability (DTL) is neither good nor bad in and of itself. It simply represents a future tax obligation that a company will have to pay in the future. Whether a DTL is considered good or bad depends on the underlying transaction that gave rise to it.

For example, a DTL may be considered good if it arises from an investment that will generate future tax deductions or credits. This could result in lower future tax payments, which could benefit the company’s cash flows and financial performance.

On the other hand, a DTL may be considered bad if it arises from an expense that cannot currently be deducted for tax purposes but will have to be deducted in the future. This could result in higher future tax payments, which could negatively impact the company’s cash flows and financial performance.

Unrealised Revenues and Expenses

Unrealized revenues and expenses are transactions that have not yet been recognized in the financial statements due to specific accounting principles. These transactions are also referred to as “non-cash” items because they do not involve an actual exchange of cash or other assets.

Unrealized revenues arise when a company has earned revenue but has not yet received payment or delivered the goods or services. For example, a company may have signed a contract to provide goods or services to a customer, but the revenue will not be recognized until the goods are delivered or the services are provided.

Unrealized expenses arise when a company has incurred an expense but has not yet paid for it. For example, a company may have purchased goods or services on credit, but the expense will not be recognized until the goods are received or the services are rendered.

Unrealized revenues and expenses are important because they can significantly affect a company’s financial position and performance. They can impact net income, cash flow, and working capital, and they must be properly accounted for and disclosed in the financial statements. Companies must also ensure that they have adequate controls in place to prevent unrealized revenues and expenses from being misclassified or misreported.

Benefits of Deferred Tax

Deferred taxes can provide several benefits to companies, including:

1. Reduced current tax liability: Deferred taxes allow companies to spread their tax liability over multiple years, which can help to reduce their current tax liability. This can free up cash flow that can be used for other purposes, such as investing in new projects or paying dividends to shareholders.

2. Improved financial performance: By deferring taxes, companies can improve their financial performance by reducing their tax expense and increasing their net income. This can make them more attractive to investors and lenders, as it demonstrates strong financial performance and cash flow generation.

3. Better management of temporary differences: Deferred taxes help companies manage temporary differences, which are differences between the tax basis of an asset or liability and its carrying amount in the financial statements. By deferring taxes, companies can avoid recognizing a large deferred tax liability or asset that may not be realized in the future.

4. Reduced volatility: Deferred taxes can help reduce the volatility of a company’s earnings by smoothing out the timing of tax payments. This is because deferred taxes are recognized as liabilities or assets on the balance sheet, which reduces the impact of fluctuations in tax rates and income on net income.

5. Improved compliance: Deferred taxes help companies maintain compliance with tax laws by ensuring that they are properly accounting for temporary differences and timing differences. This can help prevent penalties and interest charges from tax authorities, which can significantly impact a company’s financial position and performance.