Every business has to prepare different financial statements, being a statement of profit and loss, a balance sheet, and a cash flow statement as the most significant ones.
The expenses incurred, revenues earned, payables, receivables, and other items are recorded and presented in meaningful information by the financial statements.
Different accounting standards, tax reporting, and financial reporting standards are adopted in different countries. However, GAAP and IAS are the two popular financial reporting standards. GAAP(Generally Accepted Accounting Principles) are commonly followed for financial reporting.
When we talk about financial reporting, deferred taxes are a common item found on the balance sheet of most businesses. Deferred taxes can be assets or liabilities, depending on the nature of the items.
This article will talk about one of the least discussed items in financial statements: deferred tax expense. So let’s get into it without a further ado.
What Is Deferred Tax?
Before we dive into the deferred tax expense, let’s talk about the deferred taxes in general.
Deferred tax can be defined as,
The tax liability is recorded on the balance sheet due to differences in income recognition rules for financial and tax reporting purposes. The difference in the recognition standards results in a difference between the reported tax in the financial statements and the actual tax payable.
The deferred taxes arise in the company accounts because the fiscal year and the tax year might be different. When the tax is calculated by the company, it’s not paid immediately but has to be paid according to the timeline specified by IRS(Internal Revenue Service).
Deferred Tax Asset Vs. Deferred Tax Liability
The debate between deferred tax assets and deferred tax liability is also very important to understand the concept of deferred taxes.
Let’s start with deferred tax assets. It’s a non-cash item reported on the financial position statement that reduces the company’s taxable income. For instance, a company had paid tax at 21% for the financial year 2019.
However, the tax department, later on, reduced the tax to 19%. The difference of 2% will be refunded to the company. But this refund will not be a cash refund but will be adjusted in the next tax period. Therefore, it will appear as a deferred tax asset until next year.
When we talk about deferred tax liability, it’s the expenditure of the company that is deducted from the current year’s income but will be paid in the next or upcoming financial and tax year. The most common reasons for deferred tax liability include:
- The difference in timing of recognizing revenues and expenses
- Any income losses from the previous financial period carried forward to the current year
- Recording certain expenses or revenues in the tax return but not in the income statement
- Variances of gains/losses in a tax return and income statement
Simply put, deferred tax liabilities are the underpaid amount of tax by the firm, and they will be payable in the future.
What Is Deferred Tax Expense?
Now we understand the concept of deferred tax assets and deferred tax liabilities. The next thing is deferred tax expense.
According to the definition of NASDAQ,
A company’s deferred tax expenses are the non-cash expenses that contribute to the reporting company’s free cash flow. It represents the amount that is allocated for covering tax liabilities during a period but has yet to be paid.
Simply put, deferred tax expenses are the reported income tax of a company or individual in the financial statement. It can be different from the actual tax return resulting in liability or assets.
The deferred tax expense is recorded because the tax year and the financial year are not the same. Therefore, the tax is reported first and paid after completing the financial reporting.
Understanding Deferred Tax Expenses
Let’s understand the concept of deferred tax expenses as explained by Charles H. Gibson in his book on financial reporting.
According to the laws and regulations of the USA, the companies have the option of recording and recognizing specific revenues or expenses in income statements for one financial period and in tax returns for the next financial year.
When the tax is actually due and recorded in the financial statement, it’s not paid immediately but becomes tax payable. It means that the financial income statement and tax return income might be different from each other. The most common example is depreciation expense, gain/loss on sale of properties, etc.
According to the GAAP,
“the tax expense for the financial statements must be based on tax-related items on the financial statement.”
The difference between the reported tax and the tax payable is called deferred tax expense. It implies that the taxes payable by the company or individual depend on the income tax return and not the financial statement. Therefore, the tax expenses on financial statements and tax returns are different from each other.
The whole phenomenon resulting in deferred tax expense is called inter-period tax allocation. Therefore, recording such tax in the profit and loss statement is made as to the deferred tax expense.
A company had purchased machines and equipment for $100,000. The depreciation method used for the tax return is a three-year write-off. Whereas the company uses the straight-line method for internal reporting.
As a result, the numbers are as follows:
The three-year write-off for tax purposes:
1st year $ 25,000
2nd year 38,000
3rd year 37,000
The five-year write-off for financial statements:
1st year $ 20,000
2nd year 20,000
3rd year 20,000
4th year 20,000
5th year 20,000
It can be clearly seen that the machinery was written off for tax return in three years, whereas it took 5 years in the financial statement to right off the taxes.
The income tax as reported in the financial statements for the first three years will be higher than that of the tax return. The tax return will record lower taxable income due to fast depreciation.
As a result, the deferred expenses allocated for the first three years will be higher than the actual. The difference of each year will be deferred for the next period.
Recognition Of Deferred Income Taxes
The recording and recognition of deferred income taxes are done under the IAS 12 of international Accounting Standards.
According to IAS 12, the deferred income tax must be recognized when:
- The events and transactions of an entity related to taxes payable or due are recognized outside the profit and loss(in comprehensive income or equity), which results in deferred tax expense.
- The deferred tax expenses are also recognized as assets or liabilities(current/non-current) at the acquisition date and impact goodwill when applying IFRS 3 Business Combinations.
Disclosure Regarding Deferred Tax Expenses
After recognizing the criteria for the deferred tax expenses, it’s important to know the disclosure rule regarding the following clauses of IAS 12.80:
The amount of deferred tax expense(income) relating to the origination and reversal of temporary differences must be disclosed.
Similarly, the amount of deferred tax expense(income) from a change in the financial reporting and tax return due to changing standards or rates or new taxes is recognized and disclosed as the total price.
Any deferred tax assets or liabilities, whether current or non-current, have to be disclosed in the financial statements.
Some other income tax disclosures required by IAS 1 include:
- Disclosure of current tax assets, liabilities, deferred tax assets, and liabilities on the face of the financial position statement is required under IAS 1.54(n) and (o)
- Disclosure of the tax expense(income) in the profit and loss of the profit & loss statement as well as in the Other Comprehensive Income statement is required under IAS 1.82(d).
We have shared everything regarding the deferred tax expenses of a company. The deferred taxes and tax expenses are often undiscussed or under-discussed topics. However, having an understanding of deferred tax expenses is necessary for differentiating from other types of deferred taxes(assets and liabilities) and the deferred expenses reported in the financial statements of any business entity.
We will wrap it up by stating that deferred tax accounts are often called soft accounts. The reason why to call deferred tax accounts soft accounts lies in the uncertainty attached to these taxes. For instance, deferred tax expense(income) payment is uncertain. It’s not known when it will be paid or received and if it will be paid or received ever.