Deferred Tax: Understanding the Concept.

Deferred Tax: Understanding the Concept.

 

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Deferred tax is a critical concept in accounting, particularly when preparing financial statements. It represents the future tax consequences of events that have already been recognized in a company's financial statements (specifically the income statement and balance sheet). Essentially, it bridges the gap between the taxable income reported to tax authorities and the accounting income reported in the financial statements.

Here's a breakdown:

 

 

You've got it! Let's summarize the key concepts of deferred tax to help you remember them:

1. Temporary Differences (The Heart of it):

• The core concept. These are the differences between the carrying amount (book value) of an asset or liability and its tax base.
• They arise because of different accounting methods (e.g., depreciation, revenue recognition) used for financial reporting and tax purposes.
• They are temporary because they will eventually reverse (or "unwind") in future periods, leading to changes in taxable income.
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2. Tax Base & Carrying Amount:

• Carrying Amount: The asset/liability's value on the company's balance sheet (book value).
• Tax Base: The value of the asset/liability for tax purposes. This is the amount that is deductible or taxable in the future.

3. Taxable vs. Deductible Temporary Differences:

• Taxable Temporary Differences:
• Lead to future taxable amounts.
• Result in a Deferred Tax Liability (DTL) – a future tax obligation.
• Example: Accelerated tax depreciation vs. straight-line depreciation in the financial statements.
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• Deductible Temporary Differences:
• Lead to future deductible amounts.
• Result in a Deferred Tax Asset (DTA) – a future tax benefit (a potential refund or lower taxes).
• Example: Warranty expense accrued in the financials, but not yet deductible for tax purposes.

4. Deferred Tax Liability (DTL):

• A liability on the balance sheet.
• Represents future taxable amounts.
• Results from taxable temporary differences.
• The company will owe more taxes in the future.
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5. Deferred Tax Asset (DTA):

• An asset on the balance sheet.
• Represents future deductible amounts.
• Results from deductible temporary differences.
• The company will owe less taxes or may receive a refund in the future.

6. Income Tax Expense (or Benefit) & Deferred Tax:

• Changes in deferred tax (DTL or DTA) are recognized on the income statement as part of income tax expense or benefit.
• Deferred Tax Expense: arises when a DTL increases or a DTA decreases.
• Deferred Tax Benefit: arises when a DTL decreases or a DTA increases.

7. Key Steps in Accounting:

1.   Identify Temporary Differences.

2.   Calculate the deferred tax (temporary difference x tax rate).

3.   Record the DTL/DTA and the corresponding income tax expense/benefit.

8. Important Caveats:

• Tax Rate: Use the enacted tax rate expected to apply when the temporary difference reverses.
• Valuation Allowance (for DTAs): Assess the likelihood of realizing the DTA's benefit. If realization is not probable, a valuation allowance is needed.
Complexity: It can be complex due to variations in tax laws, multiple jurisdictions, and the numerous types of temporary differences that can arise.

The types of deferred tax

The types of deferred tax directly correspond to the nature of the temporary differences. There are two primary types, based on whether they create a future tax obligation or a future tax benefit:

1. Deferred Tax Liability (DTL):

• Nature: A liability on the balance sheet.
• Represents: The future tax obligation a company has because of taxable temporary differences. The company will pay more taxes in the future.
• Arises from: Taxable temporary differences.
• Key Characteristic: The carrying amount of an asset is greater than its tax base, or the carrying amount of a liability is less than its tax base.
• Examples (creating a DTL):
• Accelerated Tax Depreciation vs. Straight-Line Accounting Depreciation: The tax base (tax depreciation) is initially higher, resulting in a lower taxable income. Later on, the tax depreciation will be lower.
• Revenue Recognized for Accounting but Not Yet Taxable: If a company recognizes revenue on its income statement before it's taxed (e.g., deferred revenue that will be taxable later), this creates a DTL.

 

• Prepaid Expenses Deducted for Tax, Not Expense Recognized: If an expense is deductible for tax when it is paid, but not recognized in the financials until later, a DTL is created.

2. Deferred Tax Asset (DTA):

• Nature: An asset on the balance sheet.
• Represents: The future tax benefit a company has because of deductible temporary differences. The company will pay less taxes (or potentially get a refund) in the future.
• Arises from: Deductible temporary differences.
• Key Characteristic: The carrying amount of an asset is less than its tax base, or the carrying amount of a liability is greater than its tax base.
• Examples (creating a DTA):
• Straight-Line Accounting Depreciation vs. Accelerated Tax Depreciation: (This would reverse in future periods, creating a DTL at the start, then a DTA later.)
• Warranty Expense Recognized for Accounting but Not Yet Deductible for Tax: If a company accrues warranty expenses in its financials before it can deduct them for tax purposes, this creates a DTA.
• Allowance for Doubtful Accounts: Allowance recognized for accounting but not deductible for tax purposes until the actual write-off.
• Net Operating Loss (NOL) Carryforwards: Unused losses from prior years. These can be used in the future to reduce taxable income. This would usually create a DTA.

In summary:

Feature	Deferred Tax Liability (DTL)	Deferred Tax Asset (DTA)
Nature	Liability	Asset
Future Effect	More taxes owed	Less taxes owed or refund
Type of Diff.	Taxable temporary difference	Deductible temporary difference
Reversal	Increases taxable income in the future	Decreases taxable income in the future
Examples	Accelerated tax depreciation	Warranty expenses, NOLs

Remember that the direction of the temporary difference (taxable or deductible) determines whether you have a DTL or a DTA. This is fundamental to understanding how deferred tax works.

 

Causes of Temporary Differences (Examples):

 

I. Depreciation and Amortization:

• Scenario: Different depreciation/amortization methods or useful lives are used for accounting versus tax purposes.
• Accounting: Often uses straight-line depreciation.
• Tax: Often allows accelerated depreciation methods (e.g., declining balance, sum-of-the-years' digits) to encourage capital investment. The useful life might also be shorter for tax purposes.
• Temporary Difference: The difference between the accumulated depreciation/amortization on the balance sheet and the tax basis of the asset.
• DTL (initial years): Tax depreciation is greater than accounting depreciation, resulting in lower taxable income now but higher taxable income later when the tax depreciation is lower.
• DTA (later years): When the tax depreciation is lower than the book depreciation.
• Example:
• Asset Cost: $100,000
• Accounting Depreciation (Straight-Line, 10-year life): $10,000/year
• Tax Depreciation (Accelerated, 5-year life) results in higher depreciation in the early years and lower in the later years.

II. Revenue Recognition:

• Scenario: Different rules for recognizing revenue for accounting and tax purposes.
• Accounting: Typically recognizes revenue when earned, regardless of when cash is received (e.g., when goods are shipped or services are performed). This is generally in accordance with revenue recognition standards (IFRS 15 or ASC 606).
• Tax: May use the cash basis for tax purposes (revenue recognized when cash is received) or installment method.
• Temporary Difference: Revenue is recognized for accounting purposes before it is recognized for tax purposes.
• DTL: Income is recognized on the income statement before it's taxable.
• Example:
• Company sells goods on credit. Recognizes revenue when the goods are shipped. The tax rules allow revenue to be taxed only when cash is received.

 

III. Expense Recognition:

• Scenario: Different rules for recognizing expenses for accounting and tax purposes.
• Accounting: Often uses the accrual basis (matching principle), matching expenses to revenue in the same period, or recognizing expenses when they are incurred or a liability is established.
• Tax: May have restrictions on when an expense can be deducted (e.g., actual cash spent, or only when the expense is certain).
• Temporary Difference: Expense is recognized for accounting before it's deductible for tax purposes.
• DTL (initially): Expenses are recorded on the income statement, but cannot be deducted for tax. Thus, taxable income will be higher, leading to a higher tax obligation later.
• Example:
• Warranty expense: Company estimates and accrues warranty expenses based on sales, but can only deduct them for tax when the actual warranty work is performed.
• Bad Debt Expense: Company records an allowance for doubtful accounts, but can only deduct for tax the actual uncollectible accounts written off.

 

 

IV. Accrued Expenses:

• Scenario:
• Accounting: Companies may accrue expenses (e.g., vacation pay, bonuses, interest) that have not yet been paid.
• Tax: Certain expenses may not be deductible until the cash is paid.
• Temporary Difference: Expenses are recognized in the financials, but not deductible for tax purposes until paid.
• DTL: If an expense is accrued for accounting, but cannot be deducted for tax purposes until it is paid.
• Example:
• Vacation pay accrual: Recognized in the accounting period when earned, but not deductible for tax until the vacation pay is actually paid.

 

V. Inventory Valuation:

• Scenario: Different methods for valuing inventory.
• Accounting: FIFO, LIFO, weighted average.
• Tax: May have restrictions on LIFO or may require a specific inventory valuation method.
• Temporary Difference: If the methods result in different values for inventory.
• DTL or DTA: Dependent on the specific circumstances, this can create either a DTL or a DTA.

VI. Unrealized Gains and Losses:

• Scenario: Changes in value of investments are recognized at fair value for accounting purposes, but not for tax purposes.
• Accounting: Recognize changes in the fair value of investments in the income statement.
• Tax: Gains and losses are recognized when the investment is sold.
• Temporary Difference: Difference between the book value and tax base of the investments.
• DTL or DTA: Dependent on the situation. If the investment increased in value, a DTL is created. If the value decreased, a DTA is created.

 

VII. Start-up Costs and Research & Development Costs:

• Scenario:
• Accounting: Start-up costs and research and development (R&D) costs might be expensed as incurred, or capitalized and amortized in the financial statements (depending on the standard followed).
• Tax: May have specific rules regarding expensing or capitalizing these costs.
• Temporary Difference: Expenses recognized in the financials differently than for tax.
• DTL or DTA: Dependent on the specific circumstances.

VIII. Tax Loss Carryforwards (NOLs):

• Scenario:
• Tax: Company incurs net operating losses (NOLs) for tax purposes. Many tax systems allow these losses to be carried forward to offset future taxable income.
• Accounting: The NOL is carried forward, and creates a potential future tax benefit.
• DTA: The NOL creates a deductible temporary difference (less taxable income in the future) and a DTA is recognized.
• Valuation Allowance: Since there is always uncertainty that the company will earn future income, a valuation allowance might be needed to reduce the amount of DTA recognized.

Accounting for Deferred Tax:

 

1. Identify Temporary Differences:

• Step 1: Start with the balance sheet and the income statement.
• Step 2: Compare the carrying amount (book value) of assets and liabilities to their tax base. The tax base is the amount at which an asset or liability is reflected for tax purposes.
• Step 3: Look for differences between the two. These are your temporary differences.
• Methods to Use:
• Review the financial statements and tax returns.
• Use schedules that reconcile the book and tax treatments of various items.
• Consider using a worksheet.

2. Determine the Taxable or Deductible Nature of Each Temporary Difference:

• Step 1: For each temporary difference, determine if it's a taxable temporary difference (will result in higher future taxable income) or a deductible temporary difference (will result in lower future taxable income or a future tax refund).
• Step 2:
• Taxable temporary differences lead to a Deferred Tax Liability (DTL).
• Deductible temporary differences lead to a Deferred Tax Asset (DTA).

3. Calculate the Deferred Tax:

• Step 1: Multiply each temporary difference by the applicable tax rate.
• Step 2: This calculation provides the amount of the DTL or the DTA. Use the enacted tax rate (the tax rate that has been passed into law and is known). The calculation considers the rate expected to be in effect when the temporary difference reverses.
• Formula: Deferred Tax = Temporary Difference * Tax Rate

4.   Recognize Deferred Tax on the Financial Statements:

5.    

• Balance Sheet:
• DTL: Report the deferred tax liability as a liability on the balance sheet.
• DTA: Report the deferred tax asset as an asset on the balance sheet.
• Income Statement:
• Deferred Tax Expense (or Benefit): The change in the DTL or DTA from the beginning of the period to the end of the period is recognized as income tax expense or income tax benefit on the income statement.
• An increase in the DTL or a decrease in the DTA results in deferred tax expense.
• A decrease in the DTL or an increase in the DTA results in a deferred tax benefit.

5. Valuation Allowance (for DTAs - VERY IMPORTANT):

• Requirement: Assess whether it is more likely than not (generally defined as a greater than 50% probability) that the company will realize the future tax benefit from the DTA.
• If Realization is Uncertain:
• Reduce the DTA by creating a valuation allowance if realization of the DTA is uncertain.
• The valuation allowance is a contra-asset account.
• This adjustment helps ensure that assets are not overstated.
• The change in the valuation allowance is also reflected in the income statement as an increase or decrease to the income tax expense (benefit).
• Factors to Consider (when assessing the need for a valuation allowance):
• Past history of profitability.
• Projected future taxable income.
• The existence of reversal of taxable temporary differences.
• Tax planning strategies.
• Timing of the expiration of net operating loss carryforwards.

6. Presentation and Disclosure:

• Balance Sheet:
• DTLs and DTAs are typically presented as non-current (long-term) assets and liabilities.
• Some companies may choose to net DTLs and DTAs within the same tax jurisdiction if they have the legal right to do so.
• Income Statement:
• The income tax expense (benefit) reported includes the current tax expense (taxes owed for the current period) and the deferred tax expense (benefit) (change in deferred tax balances).
• Disclosures (required in the footnotes to the financial statements):
• A reconciliation of income tax expense (benefit) to income before income taxes.
• The nature of the significant components of deferred tax assets and liabilities.
• The amounts of any valuation allowances.
• The tax effects of temporary differences and operating loss and tax credit carryforwards.
• The amount of unrecognized deferred tax liabilities related to investments in subsidiaries.
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Example (Simplified):

Let's say a company has a taxable temporary difference of $10,000 due to the difference in depreciation methods, and the tax rate is 25%.

1.   Temporary Difference: $10,000 (Taxable)

2.   Tax Rate: 25%

3.   Deferred Tax Liability: $10,000 * 25% = $2,500

4.   Journal Entry:

o    Debit: Income Tax Expense $2,500

o    Credit: Deferred Tax Liability $2,500

o    This entry increases the DTL and increases the income tax expense for the period.

o     

Important Notes:

• Accounting Standards: Follow US GAAP (ASC 740) or IFRS (IAS 12) for detailed guidance. These standards provide comprehensive rules for recognizing and measuring deferred taxes.
• Complexity: This is a simplified overview. Real-world deferred tax calculations can be complex, involving multiple temporary differences, different tax jurisdictions, and changes in tax rates.
• Professional Judgment: Determining the correct deferred tax balances requires judgment and a good understanding of both accounting and tax laws.

 

Important Considerations:

 

 Let's focus on the most important considerations when dealing with deferred tax. These are the aspects that often cause the most confusion and require the most attention:

1. Tax Rate:

• Focus: Use the enacted tax rate. This is the tax rate that has been passed into law and is currently in effect.
• Why it Matters: The deferred tax calculation hinges on the future tax rate. The enacted rate provides the most objective measure of the future tax consequences.
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• Caveats:
• Future Rate Changes: If there is a change in the tax law (an increase or decrease in the enacted tax rate), adjust the deferred tax balances in the period the rate change is enacted (not when it's effective).
• Multiple Jurisdictions: If operating in different tax jurisdictions, you must apply the appropriate tax rate for each jurisdiction.

2. Valuation Allowance (Critical for Deferred Tax Assets):

• Focus: Determine if a valuation allowance is necessary to reduce the carrying amount of a Deferred Tax Asset (DTA).
• The Big Question: Is it more likely than not (more than 50% chance) that the company will realize the future tax benefit of the DTA?
• If "No":
• Establish a valuation allowance, which reduces the carrying amount of the DTA.
• The allowance reflects the fact that it's uncertain the company will generate enough future taxable income to use the tax benefits.
• Factors for Evaluating Realizability (Important):
• History of Losses: Prior losses and recent trends. A history of losses makes it more difficult to justify realizing the DTA.
• Future Profitability: Projections of future taxable income.
• Reversal of Taxable Temporary Differences: The existence of future taxable temporary differences that can offset the DTA.
• Tax Planning Strategies: Strategies that the company can implement to generate taxable income (e.g., accelerating revenue recognition, delaying expense recognition).
• Carryforward Periods: The length of time the company has to utilize the DTA (e.g., net operating loss carryforwards), which affects the likelihood of realization.
• Impact: The valuation allowance directly affects reported earnings and equity.
• Reassessing Annually: The valuation allowance must be reviewed at the end of each reporting period. It might need to be increased, decreased, or removed entirely depending on changing circumstances.
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3. Tax Planning Strategies:

• Focus: Companies can use tax planning to minimize their tax obligations legally. These can impact the realizability of a DTA.
• How it Works: Involves actions management can take to influence the timing or pattern of the taxable income.
• Example: Tax planning might include:
• Accelerating revenue recognition
• Delaying the payment of expenses
• Changing depreciation methods (if permitted)
• Accelerating R&D tax credits
• Impact on Deferred Tax:
• Tax planning can increase the likelihood of realizing the DTA.
• Tax planning strategies will be an important factor in determining the valuation allowance.

4. Complexity:

• Tax Laws are Complex: Tax laws can vary significantly, and they're always subject to change.
• Multiple Jurisdictions: Companies often operate in multiple tax jurisdictions, which adds complexity.
• Types of Temporary Differences: There is a wide range of temporary differences to account for.
• Need for Expertise: Deferred tax requires a solid understanding of both accounting principles and tax regulations, and often requires input from tax professionals.

5. Presentation and Disclosure:

• Clear Presentation: Clearly separate DTLs and DTAs on the balance sheet.
• Aggregation and Netting: Companies can net DTLs and DTAs only within the same tax-paying component and jurisdiction.
• Disclosure is Crucial: Detailed disclosures in the footnotes to the financial statements are essential. This includes:
• The nature of significant components of DTLs and DTAs.
• The amount of any valuation allowances.
• A reconciliation of the income tax expense (benefit) to income before income taxes.
• The amount of unrecognized deferred tax liabilities related to certain investments.

In summary, deferred tax accounting is essential for ensuring that financial statements accurately reflect a company's tax obligations and financial performance over time. It highlights the economic reality of the timing differences between accounting and tax recognition and provides a clearer picture of future cash flows related to taxes.