Deferred income tax is a liability that a company owes but has not yet paid to the tax authorities. It arises due to the difference in recognition of income and expenses for tax and financial reporting purposes, often due to timing differences. For example, a company might recognize revenue before it is taxable, or take a deduction for an expense before it is allowable for tax purposes, leading to a deferred tax liability.
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- Definition: Deferred Income Tax is a liability that occurs due to the temporary difference between the company’s accounting income, as established by the accounting rules, and its taxable income, as established by the tax code. It represents the amount the company owes but has been allowed to defer to future periods.
- Purpose: The main purpose of Deferred Income Tax is to adhere to the matching principle in accounting. This principle states that the company’s income should be matched with the expenses incurred in earning this income in the same accounting period. If a company’s accounting income is greater than its taxable income, it results in a deferred tax liability; if the taxable income is greater, it results in a deferred tax asset.
- Examples: Examples of situations that could lead to deferred tax liability include depreciation methods, pre-sales revenue recognition, and installment sales where revenue is recognized for financial reporting purposes before it is for tax purposes. On the other hand, examples of events that might lead to deferred tax assets include Net Operating Losses (NOLs) carried forward, or tax credits that are recognized for financial reporting purposes before they are for tax purposes.
Deferred Income Tax is a crucial business/finance term as it refers to the discrepancy that occurs between a company’s accounting income (income reported on financial statements) and its taxable income (income on which taxes are levied). This discrepancy usually arises due to the differences in time associated with when revenue and expenses are recognized by the tax authority and when they are actually recorded in the company’s financial books. Deferred taxes can thus pose as both assets and liabilities, as they can either signify future tax liabilities (if the deferred tax amount is to be paid in the future) or potential tax assets (if the sum can be recovered). Understanding deferred income tax can help businesses align their strategic tax planning and manage their finances more efficiently. For example, companies may use depreciation methods that are advantageous for tax purposes or manage their income and expenses to optimize their tax obligations.
Deferred Income Tax is primarily used for matching the expenses and income in appropriate accounting periods to ensure an accurate representation of a business’s financial health. It forms an essential part of accrual accounting, which is governed by the matching principle. This principle holds that companies should report associated expenses and revenues in the same period. In simple terms, deferred income tax connects a company’s tax obligation to its profitability at a particular period rather than the actual tax paid. Consequently, it promotes a better understanding of a firm’s actual economic capacity by giving a more comprehensive snapshot of its financial status, considering temporary timing differences.For example, a company could make certain investments, such as purchasing new equipment, in a particular accounting period. This expenditure might lead to a loss for the company in that period, but it could also result in significant profit boosts in future accounting periods. In such cases, the company’s taxable income, in the future, likely exceeds its accounting income. Such a company would then have to account for the deferred income tax in their financial reporting, which is meant to reflect the future tax implications of their current activities. Ultimately, deferred income tax helps to align a company’s tax duty with its profitability, bridging differences between tax accounting rules and company accounting policies, and leading to a more accurate representation of a company’s financial status in any given financial period.
Sure, here are three examples for Deferred Income Tax:1. Amazon Inc: Through the leverage of tax credits, stock-based employee compensation, and accelerated depreciation – a capital allowance, Amazon managed to carry forward deferred tax for many years. In 2018, the company reported a U.S. income before income taxes of $11.141 billion, yet they boasted an income tax provision of just $1.197 billion, much of this is due to deferred tax liabilities and assets.2. Apple Inc: In the fiscal year 2019, Apple reported a deferred tax liability of $37.2 billion. This means Apple owes, but has not yet paid, $37.2 billion in income tax, due to time differences resulting from different requirements for financial reporting and the tax code. It’s important to highlight that deferred tax won’t always translate to tax payment, especially with corporations that can leverage tax laws.3. General Motors: After having filed for bankruptcy in 2008, General Motors (GM) reported a whopping $45.4 billion in deferred income tax assets in their balance sheet in 2011. They got this by using tax loss carry for-wards and the amount represented the total losses that GM can offset against future profits for a period of 20 years.Please note that the examples may vary depending on the companies’ specific strategies, tax laws, and accounting methods.
Frequently Asked Questions(FAQ)
What is deferred income tax?
Deferred income tax is a liability that arises due to the difference between the tax basis of assets and liabilities in the financial statements and that in the tax returns. It represents the future tax obligation of a company for income that has already been recognized in the financial statements, but not on its tax returns.
How is deferred income tax calculated?
Deferred income tax is calculated based on the differences between the way that a company calculates its taxes and the way it calculates its profits for its financial statements. Preferably, it is computed by identifying the temporary differences that cause taxable amounts in future years to differ from the pretax financial income.
What is the purpose of deferred income tax?
The purpose of deferred income tax is to match the tax effects of transactions with the financial accounting recognition of those transactions. In other words, it enables the recognition of taxes in the same period as the revenues and expenses to which they relate, providing a more accurate picture of a company’s profitability and financial position.
Can you provide an example of deferred income tax?
A simple example would be a company that reports $100,000 in revenue on its financial statements, but due to differences in accounting rules, it reports $80,000 of that revenue on its tax return. The $20,000 difference will eventually be taxed, resulting in a deferred tax liability.
What is the difference between deferred tax assets and liabilities?
A deferred tax asset is an item on the balance sheet that results from overpayment or advance payment of taxes, which is expected to be recovered through future tax deductions. A deferred tax liability represents an amount that a company will need to pay in future tax periods.
Is deferred income tax considered as debt?
Not exactly. While deferred income tax is recorded as a liability on a company’s balance sheet, it is not considered debt because it does not stem from borrowing. However, it still represents an obligation for future payment.
How do deferred taxes impact business operations?
Deferred taxes can impact business decisions such as purchasing new assets or timing of income recognition. Companies may manage their operations to minimize deferred tax liabilities or increase deferred tax assets, therefore decreasing their future tax obligations.
Related Finance Terms
- Capital Gains Tax: This is a tax that companies or individuals must pay on the profits they make from selling assets.
- Tax Liability: The total amount of tax debt owed by an individual, corporation, or other entity to a taxing authority.
- Depreciation: The decrease in an asset’s value over time, which can be used as an expense to reduce taxable income.
- Profit and Loss Statement (P&L): Also known as an income statement, it is a financial report that provides information about a company’s revenues and expenses, resulting in net profit or loss over a certain period.
- Accrual Accounting: An accounting method that recognizes income and expenses when they are incurred, rather than when they are paid.