Deferred Taxes

Introduction to Deferred Assets and Liabilities

Differences between tax rules and accounting rules can lead to deferred tax assets and deferred tax liabilities.

Accounting assumes periodicity, the concept that a business's financial information can be packaged into a uniform amount of time. This amount of time is generally called a fiscal year. Though there are some specific conventions, a company can choose its own period. A typical fiscal year for large businesses is July 1 of the first year to June 30 of the next. Governmental organizations will often have fiscal years that start on October 1 so that newly elected officials have time to pass budget legislation.

The tax year, however, ends on December 31. A company may have a tax year that differs from the fiscal year it uses for financial reporting purposes. Because of the difference between the tax period and the fiscal period, a tax liability is incurred but will not be paid until a time outside of the period. Assume that Industry Corp. has a fiscal year ending on June 30 and a tax liability of $10,000. Because Industry Corp. can keep the money in a bank and earn interest, the company will not pay the taxes until the last day of the calendar year, December 31. This amount will show on the fiscal financial statements as a deferred tax liability, which is debt created as a result of the difference between financial statement income and taxable income. Though tax liabilities from out-of-period taxes are common, they are not the only situations that result in deferred tax liabilities or, as may be the case, deferred tax assets. A deferred tax asset is a current resource owned and created when the tax is paid in advance.

Because tax regulations and accounting rules differ, there are circumstances where the tax base under the two systems will differ, causing a deferred tax situation. Typically, this occurs when depreciation, or the process of allocating the cost of a fixed asset to an expense account over the life of the asset, is different under the two systems. As an example of a deferred tax liability, assume that Industry Corp. owns a software program, an asset which costs $50,000 with a useful life of five years. Suppose that this asset is depreciated straight line on the income statement. In other words, the financial statements will have a depreciation expense of $10,000.
Suppose that, for tax purposes, the company can depreciate 50 percent of the asset cost in the first year. The depreciation amount for the tax return is $25,000.
The income on the financial statements is different from the taxable income on the tax return. The higher depreciation amount on the tax return will cause the tax due on the tax return to be less than the tax expense on the income statement and thereby generate a deferred tax liability.

Effects of Deferred Taxes on Financial Statements

Deferred tax liabilities can have an unfavorable impact on a company's balance sheet.
A company's exposure to tax may appear on the income statement, balance sheet, and cash flow statement. A deferred tax liability will show on the balance sheet. Because a deferred amount is an amount yet to be paid, it will affect the analysis of financial statements, specifically the balance sheet ratios. A deferred tax liability is temporary by definition. At some point in the future, a deferred tax will reverse itself.

Reporting Deferred Taxes

A company's deferred tax assets and deferred tax liabilities are listed separately on the balance sheet and in notes.
Suppose that Industry Corp. has a software asset that will be depreciated over five years. Each year the deferred liability difference will decrease until it is completely reversed in the fifth year. In the meantime, the balance sheet will record a liability. In some cases, these tax liabilities can be quite substantial. Because the tax will reverse in the future, the company will have higher returns and higher taxes in the future. This will impact its analysis of fiscal health. An extreme, and perhaps unrealistic, example illustrates the point. Assume Industry Corp. has equity of $1,000 and $1,250 in liabilities, of which $250 is a deferred tax liability that will reverse one day into the next period. Thus, a debt-to-equity ratio (D/E) needs to be calculated in which the formula for the D/E ratio is total liabilities divided by total equity. The D/E ratio will be used to measure a company’s ability to handle its long- and short-term obligations. The debt-to-equity ratio is therefore calculated to be 1.25.
A ratio of 1.25 is unfavorable because for most companies the maximum acceptable debt-to-equity ratio is 1. A high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. As a result, without special treatment to remove the $250 in deferred tax liability, this amount would be part of Industry Corp.'s financial analysis and may distort the decision-making process indicating that the company may not generate enough cash to meet debt obligations, even though it will be reversed one day into the period. However, if the D/E ratio is adjusted and the $250 of the deferred tax liability is removed, the debt-to-equity ratio can be calculated instead to be 1.
Debt-to-Equity Ratio=($1,250$250)$1,000=1\begin{aligned}\text{Debt-to-Equity Ratio}&=\frac{(\$1{,}250\;-\;\$250)}{\$1{,}000}\\&=1\end{aligned}
This amount might be acceptable to investors and creditors.