Deferred income tax (DIT) is an accounting concept that refers to the difference between the reported income of a company and its taxable income. It can also be understood as the differences in income recognition between tax laws (IRS) and accounting methods (GAAP)

If a company reports income on its financial statements that are different from its taxable income, it has a DIT liability. This liability arises because the company will eventually have to pay Taxes on the difference between the two income amounts.

What is Deferred Income Tax?

Deferred income tax is the timing difference between the recognition of an income item on a company’s financial statements and its recognition for tax purposes.

It is a Tax Liability recorded on a company’s balance sheet as a result of a difference between tax rules and the company’s accounting methods. As a result, the firm’s payable income tax might not equal the total tax expense shown in the reporting.

For a particular year, the total tax expense might differ from the taxable amount owing to the IRS (internal revenue service) since the firm is delaying payment under accounting rule differences.

Understanding Deferred Income Tax

Accounting standards are defined by generally accepted accounting principles (GAAP). Financial accounting is regulated by GAAP. The calculation and reporting of economic events are required according to GAAP. Under US GAAP, income tax expense is recorded as a financial accounting record.

The IRS tax code, on the other hand, has special criteria for events. The differences between IRS rules and GAAP standards result in different net income calculations and, as a consequence, additional income taxes. These differences are called timing differences and they create deferred income taxes.

Types of Timing Differences

There are two types of timing differences:

1. Permanent Differences

Permanent differences are those that will never reverse themselves, such as the gain or loss on the sale of depreciable assets. These items are not included in deferred income taxes.

2. Temporary Differences

Temporary differences are those that will eventually reverse themselves. The most common temporary difference is the mismatch between the timing of when an expense is reported on the financial statements and when it is deductible for tax purposes.

For example, suppose a company pays its employees bi-weekly but recognizes the salaries earned in the current period on its financial statements monthly. The result is a temporary difference. The amount earned by the employees in the current period is reported as income on the company’s financial statements, but it is not taxable until the following year.

The temporary difference creates a deferred income tax liability because the company will eventually have to pay taxes on that income. The deferred income tax liability is reported on the balance sheet as a long-term liability.

Deferred income taxes represent a significant portion of a company’s total tax liability. They can have a significant impact on a company’s financial statements and tax bills. For this reason, it is important for investors to understand how deferred income taxes are calculated and what factors can cause them to change.

What Causes Deferred Income Taxes?

There are two primary causes of deferred income taxes:

1. Accounting Methods

2. Temporary Differences

Accounting methods are the rules that a company uses to record its income and expenses. The most common accounting method is accrual basis accounting. Under this method, income is reported when it is earned, even if it is not received until later. Expenses are reported when they are incurred, even if they are not paid until later.

The accrual basis method is generally used for financial accounting, but there are other methods that can be used for tax purposes. The cash basis method, for example, only reports income when it is received and expenses when they are paid.

The use of different accounting methods can cause deferred income taxes. For example, suppose a company incurs $100 in expenses in one year but does not pay them until the following year. The company will report the expenses on its financial statements using the accrual basis method. However, for tax purposes, the company will use the cash basis method and will not deduct the expenses until they are paid. As a result, the company will have to pay taxes on the $100 of income in the year it is earned, even though it will not receive the cash until the following year.

This example illustrates a temporary difference. The expenses are deductible for tax purposes in the year they are paid, but they are reported on the financial statements in the year they are incurred. This temporary difference will eventually reverse itself, but in the meantime, it creates a deferred income tax liability.

Types of Deferred Income Tax

1. Deferred Income Tax Asset

When the Company has already paid the tax, an asset is created known as a deferred tax asset. The advantage of having deferred tax assets is that in future years, the Company will have fewer taxes to pay.

So, when a firm clears its tax liability for a subsequent year in advance, the deferred tax asset is realized, and it becomes an income on the Profit and Loss statement. A deferred tax asset is reported on the balance sheet as an asset. It is important to note that a deferred tax asset is only an accounting entry. It does not represent cash that the company has on hand.

2. Deferred Income Tax Liability

When the Company underestimates its tax obligations, it creates a deferred tax liability. The liability is established not because the company has defaulted on its income taxes but rather owing to timing mismatches or accounting rules that result in lower tax expenditure than required by the company.

A deferred tax liability (DTL) is a tax payment that a firm has stated on its balance sheet but will not have to pay until the next year’s tax return. A payroll tax holiday is an example of a deferred tax liability, which allows firms to delay paying their payroll taxes until a later date. The company receives a present financial benefit now, but it becomes responsible for paying the debt in the future.

How Deferred Income Tax Works

The amount of deferred income tax is calculated by multiplying the tax rate by the amount of the temporary difference. The tax rate used is the rate that is expected to be in effect when the temporary difference reverses itself.

For example, suppose a company has a temporary difference of $100 and the tax rate is 20%. The deferred income tax liability would be $20.

When the temporary difference reverses itself, the deferred income tax liability will become an asset or a liability, depending on whether the Company’s tax rate has gone up or down.

If the tax rate has gone up, the deferred income tax liability will become an asset. This is because the company will be able to deduct the expenses in the year they are paid, but will not have to pay taxes on the income until the following year.

If the tax rate has gone down, the deferred income tax liability will become a liability. This is because the company will have to pay taxes on the income in the year it is earned, but will not be able to deduct the expenses until the following year.

The deferred income tax asset or liability is reported on the balance sheet as a long-term asset or liability.

IRS vs. GAAP

Some of the differences between IRS and GAAP on different grounds are-

1. Recognition of Deferred Taxes

According to the IRS, only those deferred taxes which are “more likely than not” to be realized should be recognized. On the other hand, GAAP requires that all deferred taxes should be recorded in the financial statements.

2. Allowance for Bad Debts

The IRS allows businesses to deduct the allowance for bad debts in the year when it is incurred. However, GAAP requires businesses to deduct the allowance for bad debts in the year when the debt is actually written off.

3. Inventory

The IRS allows businesses to value inventory at its lower of cost or market value. GAAP, on the other hand, requires businesses to value inventory at its replacement cost.

4. Prepaid Expenses

Prepaid expenses are those which have been paid for but have not yet been used up or consumed. The IRS allows businesses to deduct prepaid expenses in the year when they are paid. GAAP, however, requires businesses to deduct prepaid expenses in the year when they are actually used up or consumed.

Examples of Deferred Income Tax

Suppose a company pays its employees on the last day of every month. The company will have to pay taxes on the salaries earned in the month, but will not be able to deduct the expenses until the following year. This creates a deferred income tax liability.

Another example is when a company buys office supplies on credit. The company will have to pay taxes on the income in the year it is earned, but will not be able to deduct the expenses until the following year. This creates a deferred income tax liability.

A deferred income tax asset can be created when a company has already paid taxes but has not yet deducted the expenses. For example, suppose a company pays its employees on the first day of every month. The company will have to pay taxes on the salaries earned in the month, but will not be able to deduct the expenses until the following year. This creates a deferred income tax asset.

Another example is when a company buys office supplies on credit. The company will have to pay taxes on the income in the year it is earned, but will not be able to deduct the expenses until the following year. This creates a deferred income tax asset.

Conclusion!

Deferred income taxes are a complex topic, but it’s important to have a basic understanding of them if you want to be able to read and understand financial statements.

The key things to remember are that deferred income taxes are created when there is a temporary difference between the amount of income that is reported on the tax return and the amount that is reported on the financial statements and that deferred income taxes are either assets or liabilities depending on whether the company’s tax rate has gone up or down.

What do you think? Do you have a clear understanding of deferred income taxes now? Leave a comment below and let us know!

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