Deferred Income Tax is the tax effect of timing differences between the recognition of revenues and expenses for accounting purposes and their recognition for tax purposes. These timing differences create deferred tax liabilities when taxable income is lower than accounting income, and deferred tax assets when taxable income is higher.
Why is Deferred Income Tax Important?
Deferred Income Tax is important because it:
Aligns Tax Expense with Accounting Income: Ensures that tax expense on the income statement reflects the tax consequences of transactions in the same period.
Reveals Future Tax Obligations or Benefits: Indicates amounts that will affect future cash taxes payable or refunds receivable when timing differences reverse.
Supports Accurate Financial Analysis: Provides a complete view of a company’s tax position, preventing distortion of current period profitability.
How is Deferred Income Tax Calculated?
Deferred Income Tax is measured by applying the enacted tax rate to temporary differences that will reverse in future periods:
Deferred Income Tax = Temporary Difference × Enacted Tax Rate
Where:
Temporary Differences include items such as depreciation methods, allowance for doubtful accounts, and revenue recognition differences.
Enacted Tax Rate is the statutory rate expected to apply when the temporary differences reverse.
Deferred tax assets arise from deductible temporary differences and carryforward items (e.g., net operating losses), while deferred tax liabilities arise from taxable temporary differences (e.g., accelerated depreciation for tax purposes).
Additional Considerations
Valuation Allowance: Deferred tax assets are recognized only to the extent it is probable they will be realized; a valuation allowance reduces assets if recovery is uncertain.
Rate Changes Impact: Changes in tax laws or rates require remeasurement of deferred tax balances, affecting current and prior period earnings.
Disclosure Requirements: Companies must disclose significant components of deferred tax assets and liabilities, the nature of temporary differences, and valuation allowance judgments in the notes to the financial statements.