What Is Deferred Income Tax?
Deferred income tax is a result of standard accounting practices differing from the current tax law. Because of these differences, businesses can sometimes pay more or fewer taxes than they are required to do so. When a business owes the government money, this is called a “deferred income tax liability.” When the business has overpaid their taxes, this is called a “deferred income tax asset.”
Businesses can end up with a deferred income tax liability for a variety of reasons, including different methods of calculating depreciation, installment sales for items that are paid off over time, and other differences between generally accepted accounting principles (GAAP) practices and IRS calculations. In many cases, deferred income tax liabilities and assets naturally even out over the course of time.
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What Is GAAP?
GAAP is an acronym for “generally accepted accounting principles.” Among other financial calculations, income tax for businesses is determined according to these guidelines. GAAP is used by companies and accountants in order to properly calculate and disclose financial information. GAAP is based on a combination of standards set by policy boards and common best practices.
The IRS, however, uses a method to calculate income tax that can sometimes differ from generally accepted accounting principles. Because of these differences, the income tax that the business pays is occasionally different from the income tax that the IRS has specified. When this happens, the business ends up with a deferred income tax asset or liability, depending on whether they have over- or under-paid.
How Do Deferred Tax Liabilities Happen?
Companies calculate the income tax that they owe based on GAAP. Since the federal government uses a different method, however, there can sometimes be discrepancies in the amount owed. In particular, companies using GAAP best practices and the IRS may come up with two different totals for net income, which impacts the amount of tax due.
If the difference between the company’s total net income and the IRS total is positive, the company has a deferred income tax asset that will result in them paying less money in future quarters. If the difference between them is negative, the company owes the IRS money in the form of a deferred income tax liability and will have to pay more income tax in the future.
Common Examples of Deferred Income Tax
The most common reason for a deferred tax liability to occur is depreciation. Depreciation happens when the real or perceived value of an asset decreases over time. This can be due to physical wear and tear, especially for objects with a limited life span, or can be due to the perceived loss of value in a particular asset.
A common way to think about depreciation is to use the example of purchasing a new car. The car automatically depreciates in value when you drive it off the lot, even though it’s in virtually the same condition as before you bought it. This is an example of perceived depreciation that has nothing to do with physical wear and tear. Once you drive a hundred thousand miles on the car, however, the value of the vehicle will have depreciated further for physical reasons.
GAAP standards and tax law differ significantly on the issue of reporting depreciation. In accordance with GAAP, businesses can use a variety of methods to measure depreciation. The IRS, meanwhile, uses a different method than common GAAP methods. Many businesses measure the depreciation of assets in their financial records through a straight-line basis that calculates depreciation evenly over a certain period of time, while using another method known as modified accelerated cost recovery system (MACRS) in their tax records, which allows them to record a greater level of depreciation sooner. Although these calculations eventually even out over time, this can often result in a difference in net income totals and income tax calculations in the short term.
Installment sales are another common cause of deferred income tax liabilities and assets. If a company sells a consumer a product with a fixed price paid on an installment basis, they may record the total price and the installment payments differently in terms of financial accounting and revenue for tax purposes. This may result in a temporary deferred income tax liability until the customer has paid for the item in full, at which point the discrepancy will be resolved.
Importance of Liability Reporting
If left unattended, deferred income tax liabilities will accrue as taxes due from the company to the federal government. Some deferred income tax liabilities are temporary differences that will even out over the course of time, as in the case of depreciation or installment plans. In other cases, however, deferred income tax liabilities represent permanent differences that may take a much longer time to reconcile.
Deferred income tax liabilities and assets are important to take into account when planning for a company’s future. Depending on whether you have a liability or an asset, deferred income tax can significantly affect your future cash flow. In the case of a deferred income tax liability, it’s especially important to take into consideration since you will end up paying deferred income tax down the line.
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