Deferred tax

From Wikicpa

Deferred tax is defined as a future tax liability or asset, resulting from temporary differences between the book value of assets and liabilities, and their tax value.

The need for deferred tax accounting arises because companies often postpone or pre-pay taxes on profits pertaining to a particular period.

When a company arrives at its profits or losses for a period, it does so after deducting all the expenses, including the tax for the period, from the revenues earned. But a company's profits/losses reported to investors often differ, sometimes substantially, from the profits the government lays claim to.

Situations where there is a deferred tax liability

There may be a difference in the way certain items of expense are allowed to be treated for tax purposes and how a company actually treats them.

Tax laws allow a 100% depreciation in the first year after a company acquires certain assets (See Section 179 expense). But a company may actually write off the depreciation over a larger number of years in its financial statements. The company may charge depreciation at lower rates than allowed under tax laws. Or it may use a different method of charging depreciation.

Tax laws may allow a company to deduct certain expenses in full in a single year, but it may phase out the charge over a number of years.

Accounting treatment

Under the old system of accounting only for current taxes, the company's profits would be artificially high in the first year (due to the tax savings).

The profits would, however, be lower in the subsequent years, as the tax laws in the subsequent years would not recognize the depreciation charge or the amortized expense, as the case may be.

But the new accounting standard requires that a company carve out a part of its current year's profits (equal to the future tax liability on such transactions) as a deferred tax liability. The deferred tax liability serves the purpose of a reserve, which will be drawn down in the future years to meet the company's higher tax liability in those years.

By recognizing deferred tax liabilities in its books, a company makes sure that the tax liability for any particular year is reflected in that year's financial statements and does not carry over to future profits.

It brings investors one step closer to understanding exactly how much of a company's profits for a period are from its operations (rather than from fiscal savings).