Navigating deferred taxes can be a confusing process, and the accounting rules for reporting deferred taxes can sometimes seem arbitrary and nonsensical when viewed through the lens of real-world economics. Here’s a brief article to help simplify this complex subject.
What are deferred taxes?
Companies are required to pay income tax on taxable income as defined by the IRS. On their Generally Accepted Accounting Principles (GAAP) financial statements, however, companies record income tax expense based on accounting “pretax net income.”
In any particular year, your taxable income (for federal income tax purposes) and pretax income (as reported on a GAAP income statement) may differ substantially. Depreciation expense is typically the reason for this temporary difference.
The IRS allows companies to use accelerated depreciation methods to lower taxes that are paid in the early years of an asset’s useful life. Many companies may also choose to claim Section 179 deductions and bonus depreciation for the year an asset is put into service.
An alternative route that many companies take for GAAP reporting purposes is to use straight-line depreciation. At the beginning of an asset’s useful life, this typically causes taxable income to be dramatically lower than GAAP pretax income. That said, as the asset gets older, this temporary depreciation expense is reversed.
Understanding differing depreciation methods
Using differing depreciation methods for tax and accounting purposes causes a company to report deferred tax liabilities. In simple terms, this means that by claiming higher depreciation expense for tax purposes than for accounting purposes, the company has momentarily reduced its tax bill but must make up the difference in later tax years.
Deferred tax assets can come from other sources like operation loss carryforwards, tax credit carryforwards, and capital loss carryforwards.
How should deferred taxes be reported on financials?
When a company’s pretax and taxable incomes differ, it is required to record deferred taxes on its balance sheet.
This can go one of two ways. If a company pays the IRS more tax than an income statement reflects, it records a deferred tax asset for the future benefit the company is entitled to receive. If the opposite occurs and the company pays less tax, it must record a deferred tax for the additional amount it will owe in the future.
Like other liabilities and assets, deferred taxes are classified as either current or long-term.
No matter their classification, though, deferred taxes are recorded at their cash value (that is, with no consideration of the time value of money). Deferred taxes are also based on current income tax rates. The company can revise its balance sheet, in which case change flows through to the income statement if tax rates change.
Unlike deferred tax liabilities which are recorded at their full amount, deferred tax assets are offset by a valuation allowance that reflects the potential of an asset expiring before the company can utilize it. Determining the amount of deferred tax valuation allowance to log is at the discretion of management is highly subjective. It’s important to note that all changes to this allowance will flow through to the company’s income statement.
Today, or later on down the line?
For financial statement users, it’s critical not to lose sight of deferred taxes. A company with significant deferred tax assets may be able to reduce its tax bill in the future and save much-needed cash on hand by claiming deferred tax breaks.
On the other hand, a company with considerable deferred tax liabilities will have already taken advantage of tax breaks and may need additional cash on hand to pay the IRS in future tax years.
Questions? Smolin can help
Still unsure of how deferred taxes might affect your business? If you would like to discuss any of these issues or gain a better understanding of tax rules for businesses, our CPAs can help. Contact us to get started.