Deferred Income Tax

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What is a 'Deferred Income Tax'

A deferred income tax is a liability recorded on the balance sheet that results from a difference in income recognition between tax laws and accounting methods. For this reason, the income tax payable for a company may not equate to the total tax expense reported. The total tax expense for a specific fiscal year may be different than the tax liability owed to the IRS as the company is postponing payment based on accounting rule differences.

BREAKING DOWN 'Deferred Income Tax'

Situations may arise where the income tax payable on the tax return is greater than the income tax expense on the financial statements. When this occurs, previous balances of deferred income tax liabilities are extinguished. In time, if no other reconciling events occurred, the deferred income tax account would net to $0. However, if there was no deferred income tax liability account, a deferred income tax asset would be created. This account would represent the future economic benefit expected to be received because income taxes were charged in excessed based on GAAP income.

Financial Accounting vs. Tax Accounting

Financial accounting standards are guided by generally accepted accounting principles (GAAP). GAAP accounting requires calculation and disclosure of economic events in a specific manner. In addition, income tax expense — a financial accounting account — is calculate using GAAP income. Meanwhile, the Internal Revenue Service (IRS) tax code specifics certain rules on the treatment of events. The differences between these two sets of guidelines result in different computations in net income and the subsequent income taxes due on that income.

Financial Statement Classification

A deferred income tax liability is classified on the balance sheet. However, it may be classified as either a short-term liability or long-term liability based. If the deferred tax liability is presumed to be paid in the next 12 months, it must be recorded as a current liability. Otherwise, it is of a long-term nature. Deferred income tax liabilities are the difference between the income tax expense reported on the income statement and the income tax payable reported on the balance sheet.

Example of Deferred Income Tax

The most common situation that generates a deferred income tax liability is from differences in depreciation methods. GAAP allows for businesses to choose between multiple depreciation methods. However, the IRS requires use of one depreciation method different from all GAAP methods. For this reason, the amount of depreciation recorded on the financial statements is commonly different than the calculations found on a company’s tax return. Over the life of the asset, the value of the depreciation in both areas changes, and at the end of the life of the asset, no deferred tax liability exists as total depreciation between the two methods is equal.