Deferred income tax is the future tax consequence of a difference between what an item is carried at on the books and what it is carried at for tax. Because the two systems take the same revenue or cost into account in different years, an amount that will be taxable or deductible in a later year already exists at the reporting date, and it is recorded now as a deferred tax liability or a deferred tax asset rather than left to appear when the cash tax changes.
Two kinds of difference arise between the systems: a difference between the amount of taxable income and pretax financial income for a year, and a difference between the tax bases of assets or liabilities and their reported amounts in financial statements (FASB Statement No. 109, paragraph 10). It is the second kind that produces a deferred balance.
The Assumption Underneath It
Nothing about a difference in basis is automatically a tax effect. The standard reaches one through an assumption it states plainly: an assumption inherent in a statement of financial position prepared in accordance with generally accepted accounting principles is that the reported amounts of assets and liabilities will be recovered and settled respectively, and on that assumption a difference between the tax basis of an asset or liability and its reported amount will result in taxable or deductible amounts in some future year when the reported amounts of assets are recovered and the reported amounts of liabilities are settled (FASB Statement No. 109, paragraph 11).
That is why the balance is recognised today. The future tax is not a forecast of what management intends, it follows from carrying the asset or liability at the amount the statements already show.
The Four Patterns
The standard sets out four ways the timing can diverge, each with its own example, and every deferred balance a firm meets is one of them (FASB Statement No. 109, paragraph 11).
| The book and tax timing | The standard’s example | What it produces later |
|---|---|---|
| Revenues or gains taxable after they are recognized in financial income | A receivable from an installment sale | Future taxable amounts when the asset is recovered |
| Expenses or losses deductible after they are recognized in financial income | A product warranty liability | Future deductible amounts when the liability is settled |
| Revenues or gains taxable before they are recognized in financial income | Subscriptions received in advance | Future deductible amounts when the liability is settled |
| Expenses or losses deductible before they are recognized in financial income | Depreciable personal property written off faster for tax than for reporting | Future taxable amounts, since recovery will exceed the remaining tax basis |
Source for all four rows and their examples: FASB Statement No. 109, paragraph 11.
Reading the last column tells you which balance you are looking at without memorising anything. A pattern ending in future taxable amounts produces a deferred tax liability. A pattern ending in future deductible amounts produces a deferred tax asset, and the two rows that do so, the warranty liability and the advance payment, are worked through in deferred tax assets rather than here.
The fourth row is the one most private clients have. Cost recovery taken faster on the return than in the accounts leaves a lower tax basis than book carrying amount, and the gap is a promise of tax to come rather than tax avoided.
What Gets Computed Each Year
The annual exercise is a procedure rather than a judgment, at least until the last step. Deferred taxes are determined separately for each tax-paying component in each tax jurisdiction, and that determination identifies the types and amounts of existing temporary differences and the nature, amount and remaining carryforward period of each operating loss and tax credit carryforward, then measures the total deferred tax liability for taxable temporary differences and the total deferred tax asset for deductible temporary differences, in each case using the applicable tax rate (FASB Statement No. 109, paragraph 17).
Only after that does judgment enter, in deciding how much of the asset will actually be usable, which is the work in valuation allowance.
The Expense Is a Movement, Not a Payment
This is the sentence that resolves most of the confusion around the term. Deferred tax expense or benefit is the change during the year in an enterprise’s deferred tax liabilities and assets (FASB Statement No. 109, paragraph 16).
So the deferred piece of a tax charge is a movement between two balance sheet dates, not an amount anybody remits. Nothing in it is payable to a taxing authority this year, and nothing in it is refundable. How that movement combines with the amount actually payable to produce the reported charge is set out in accounting for income taxes.
Where a Firm Meets It
At the close, and the recurring work is maintaining the difference schedule rather than recomputing the concept.
The schedule that matters lists each temporary difference with its book carrying amount, its tax basis and the resulting difference, and it has to reconcile from one year end to the next. Two habits keep it honest. Roll it forward rather than rebuilding it, so a difference that quietly disappeared has to be explained rather than absorbed. And separate the differences that will reverse from the book to tax differences that never will, because a permanent difference changes the effective rate and produces no deferred balance at all, a split worked through in the income tax provision.
The classification is not a choice either. A difference is assigned to the asset or liability side by which of the four patterns it belongs to, and netting them before that assignment hides the character of what is there.
Common Questions
A difference between the tax basis of an asset or liability and its reported amount, coupled with the assumption that the reported amount will be recovered or settled (FASB Statement No. 109, paragraph 11). A difference in the rate, in the entity’s cash position or in when the tax is paid does not trigger it; only a basis difference that will unwind into a taxable or deductible amount does.
Neither, and treating it as either misreads what it is. It is a measurement of timing, so a deferred tax liability is not a debt the business has taken on and a deferred tax asset is not money owed to it. The useful questions are whether the differences reverse when the schedule says they will, and for the asset side, whether there will be income to use it against.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own close and provision work through a trial task so its reviewers stay on the judgment calls.
