What Is Deferred Tax? Definition, Overview, and How It Works

Taxation is one aspect of the economy the government uses to gain revenues and everyone including companies and individuals is liable to pay tax. There are several tax rules guiding tax payment, and various countries have their tax rules. Sometimes, there might be similarities between tax rules.

Still, one thing that stands out is that the accounting methods used by companies in preparing financial statements might differ from that of the tax authorities leading to discrepancies in both parties’ records.

One area of tax where a company’s accounting method differs from tax rules is in the case of deferred tax. Regarding taxable income, tax authorities do not regard some things like warranties.

Another aspect might be in the depreciation method a company chooses. All these could lead to either a deferred tax liability or asset.

In this article, we’ll be looking at what is deferred tax? Its definition, overview, and how it works. 

What Is Deferred Tax?

According to Wikipedia, Deferred Tax is a national asset or liability that reflects corporate income taxation on a basis that is the same or more similar to the recognition of profit than the taxation treatment. 

It refers to either a liability or asset entry on a company’s balance sheet concerning tax owed or overpaid due to temporary differences. 

Defer tax means tax that is either owed or overpaid because of a temporary difference. This temporary difference is seen as a difference between the company’s income and the tax income which can be resolved later.

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How Does Deferred Tax Work?

Deferred tax can happen in two ways either as an asset or liability. These two items will appear as entries on the company’s balance sheet. They both represent the negative or positive amount of tax owed.

A company can have only a tax liability or a deferred tax asset. To determine which is an asset or a liability depends on whether the tax is owed or overpaid. 

What is Deferred Tax Asset?

Deferred tax asset occurs when a company overpays its tax due for a specific period, this can be recorded as a deferred tax asset on the company’s balance sheet.

When businesses overpay taxes or pay taxes in advance this can be seen as an asset which means the business is eligible to receive a tax break or reduction on their next tax filing. 

One benefit of paying tax in advance or overpaying tax for businesses is that it reduces the burden of future tax dues. They wouldn’t have to worry about the amount of tax they’ll pay in their next tax filing or if they’ll be able to meet up with the amount required. 

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It also happens when losses are carried over from the previous accounting period to the new accounting period. This can also be claimed as an asset in the new accounting period.

Example of deferred tax asset calculation

Imagine a phone production company estimates, based on previous experience, that the probability that a phone will be returned for warranty repair in the coming year is 4% of the total production. If the company’s total revenue in year one is $8000 and the warranty expenses in its book are $320 (2%×8,000), then the taxable income is 7,680.

Most tax authorities do not allow companies to subtract expenses based on expected warranties. This means the company’s taxable income is the whole $8,000.

Assuming the tax rate for companies is 30%, the difference of $96 ($320×30%) between the tax payable in the income statement and the actual amount of tax paid to the tax authorities is the deferred tax.

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What Causes Deferred Tax Asset?

A company’s balance sheet reflects deferred tax assets if it has overpaid its tax dues or it paid in advance. 

This might happen because of a difference in the time a company pays its tax and when the tax authorities credit it. If it shows that the company overpaid its tax, they’ll be refunded.

In circumstances like this, the company’s balance sheet should show taxes they paid or money due to them.

Deferred Tax Liability

A Deferred tax liability happens when a company has a specific amount of income for an accounting period that differs from the taxable amount on their tax returns. If such an amount is less than the estimated tax, it should be recorded as a deferred tax liability in the balance sheet. 

One disadvantage of having accrued tax or paying a lesser tax amount than the expected tax amount is that you’ll be owing to the tax authorities.

It increases your tax burden which means while you’re trying to pay your present tax you’ll also be thinking of how to clear off the previous amount you’re owing. 

Example of deferred tax liability

Imagine a company with a building classified as an asset and they decide to use a particular type of depreciation method, say an accelerated method that allows higher deductions earlier in ownership of the asset and decreased deduction later.

This method then differs from the slower straight-line method used by the tax authorities which allows the depreciation to be spread equally over the useful life of the assets. 

This method impacts how much the charges will be for each accounting year. These charges can be claimed as a capital allowance.

Since the depreciation method selected by the company would initially lead to a larger amount than the depreciation method selected by the tax authorities, their income will be much more than what is considered a taxable income.

In such cases, the temporary difference will be added as deferred tax liability in the books. 

What Causes Deferred Tax Liability?

A company’s balance sheet reflects deferred tax liability if it underpaid its tax due or has accrued tax expenses.

This occurs when a company uses a different method from the tax authorities to prepare its financial books. If it chooses an accounting method that reduces its taxable income or makes it lower than what the tax authorities calculated, it’ll be liable to pay back the amount owed.

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In such cases, the company’s balance sheet would reflect the amount of accrued tax or tax owed to the tax authorities.

See Also: What is Tax Planning? Why do You Need It in 2022

Deferred tax and taxable temporary difference

The taxable temporary difference is an important concept to know about deferred tax. The taxable temporary difference happens when a company has an asset with a liability value that doesn’t match the current taxable value of the asset. This may happen when accounting and tax rules differ in how an asset is accounted for.

The taxable temporary difference affects a company’s financial account because they show that income and expenses appear within the same accounting period, while the taxable amount is paid in a different accounting period. A temporary difference can be deductible or taxable. 

What Is The Benefit of Deferred Tax?

A company can only enjoy benefits from deferred tax if they have a deferred tax asset.

Some benefits include :

  • The company enjoys tax relief for a specific time. Since they already paid tax in advance they’ll get some tax relief from the tax authorities.
  • Companies that pay their taxable income in advance for not have to worry about meeting up with the required tax amount for the next accounting period.
  • You’ll record it in your book as an asset which means the tax authorities are liable to either refund the amount to you or use it to settle the next tax you’ll pay later. 
  • Deferred tax assets increase the income of the company and reduce expenses.

What are The Disadvantages of Deferred Tax?

When we’re looking at the disadvantages of deferred tax, we would be looking at the opposite of asset which is the liability.

Some disadvantages of deferred tax include:

  • Companies are not going to enjoy the benefits of tax relief because they’ll be the ones owing to the tax authorities
  • It increases the expenses of a company and reduces the profit.
  • It increases the amount of tax you’ll be expected to pay in the future. In this case, if you don’t meet up with that amount in the future it keeps accruing.
  • Also, it will appear in your company’s financial books as an amount you’re owing the tax authorities which you’ll be expected to remit at a certain date.

However, note that most companies might likely have deferred tax liability because they’re capital intensive. This means they purchase fixed assets for the growth of their business.

What is the Difference Between Deferred Tax Liability and Asset?

A deferred tax asset means a financial benefit to the company while a liability refers to a future tax obligation or accrued tax amount.

Deferred tax assets positively impact the company’s financial statement while a deferred liability harms the company’s financial statement.

Tax asset means the tax authorities are liable to refund your money back or grant you a tax relief while a tax liability means you’ll owe the tax authorities, you’re liable to pay them whatever amount of money you’re owing.

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Deferred tax asset occurs when a company has overpaid its tax dues while deferred tax liability occurs due to the company using a different accounting method from the tax authorities.

What Types Of Information Causes Deferred Tax Asset or Liability?

Here is some information that causes tax liability or assets on a company’s book. They meant look irrelevant but remember in accounting every figure or amount can impact your company’s financial performance either positively or negatively.

Having a solid knowledge of this information will better help you understand deferred taxes. 

  • Policy on amortizing financial assets.
  • Warranty, bad debt or write down estimates. 
  • Policy on capitalizing or depreciating fixed asset
  • Policy on revenue recognition

See Also: What is a Tax Warrant? Definition, Overview, and how it works

Understanding The Effects

After equipping yourself with information about the changes and causes of deferred tax, it is also necessary to analyze the impact this would have on the future of the company’s financial statements.

It is important to know that deferred tax liability or assets can have either a negative or positive effect on the company’s cash flow.

An increase in tax liability or a reduction in asset is a cash inflow while a reduction in tax liability or an increase in asset means cash outflow.

Analyzing the changes in deferred tax should help you know the future trends these entries are moving towards. Will there be a continuous increment or will it reduce in the future?

FAQs

What is deferred tax?

Deferred tax refers to either a liability or asset entry on a company’s balance sheet concerning tax owed or overpaid due to temporary differences. 

What is deferred tax liability?

Deferred tax liability happens when a company has a specific amount of income for an accounting period that differs from the taxable amount on their tax returns.

Deferred tax asset?

Deferred tax asset occurs when a company overpays its tax due for a specific tax period, this can be recorded as a deferred tax asset on the company’s balance sheet.

What is deferred tax expenses?

Deferred tax expenses are a non-cash expense that provides a source of free cash flow.

Where do deferred taxes go?

Deferred taxes are carried in a company’s balance sheet so that they can be used in the future to reduce the taxable income.

Conclusion

Deferred tax occurs when liability or asset in a company’s balance sheet reflects tax owed or overpaid due to a temporary difference.

Some entries like warranties usually trigger tax asset because tax authorities do not record them while tax liabilities occurs when a company uses an accounting method that is different from the tax authorities’ rules to calculate some assets.

Tax liability does not mean a company is running at a loss, in most cases they might be capital intensive which means they acquire new fixed assets to boost the company’s production.

Now acquiring these assets means they use accounting methods different from the tax authorities’ rules to calculate entries like depreciation. Both deferred tax assets and liability impact the company’s overall performance. 

I hope this article helps you understand more about this subject.

References

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