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What is Deferred Income Tax? Examples & Importance

The concept of deferred income tax in a company’s balance sheet and cash flow statement is relatively easy to grasp from an ideal perspective, but when these liabilities (or assets) change year-to-year it can become more complicated.

Here’s what the basics of GAAP accounting have to do with deferred income tax liabilities and assets. Sometimes, because of this rule that is based on basic accounting principles (GAAP), an accountant may not be able to account for certain cash transactions.

GAAP is a method to try and understand the financials of a business, but it can differ materially from the company’s cash outflows or inflows. It’s important to get an intuitive feel for how these two statements relate because they don’t always go hand-in-hand.

While GAAP tells us what has happened in the past with respect to income/expense recognition, it doesn’t tell us about future events that will impact metrics like net worth.

Understanding deferred taxes is another step towards mastering fundamental analysis by comprehending which factors may have different effects on each statement of accountancy (P&L vs balance sheet).

When it comes to taxes & accounting, The IRS is not a fan of GAAP standards. They don’t care about specific guidelines, they just want their money – so you can never be too careful when filing your returns.

KEY TAKEAWAYS:

  • A deferred income tax is a result of the difference in accounting methods and the IRS. This results from their different rules for when to start recognizing revenue as taxable or not, so it differs by the company what kind of taxes are due at any given time – but they’re usually paid later on with interest.
  • Income tax is the responsibility of companies, and deferred income taxes are a liability that takes up space on company balance sheets.
  • The difference in depreciation methods used by the IRS and GAAP is often to blame for deferred tax. Deferred tax can be a result of using different accounting standards, such as FASB or IASC.
  • A short-term financial obligation is one that will need to be paid in the next 12 months, while an example of a long term debt would include things like mortgages which must last for many years before they are due.

income tax liability

Let’s Understand in Deep

Generally accepted accounting principles (GAAP) offer guidelines that dictate how financial statements are calculated and displayed. GAAP is designed to present economic events in a specific manner.

Which includes the calculation of income tax expenses for an organization’s particular use. Income taxes are often taken into account when determining whether or not an entity has made enough money during any given fiscal year; as such, this can be seen as one way of judging its success.

In contrast, there are special rules in the IRS tax code on how events should be treated. The differences between these and GAAP guidelines result in different computations of net income- which then results in a difference when it comes time for taxes.

In many cases, the income tax payable on a return is higher than that of an expense for accounting purposes. When this happens there may be discrepancies in the deferred taxes account and it can even reach $0 if no other reconciling events take place.

Without a deferred income tax liability account, there would be an increase in the amount of taxes to be paid. This is because when GAAP standards give less than what’s required by law, this unaccounted difference will have to go into effect at some point for it not to become too burdensome.

Examples of Deferred Income

When it comes to taxes, we know that there are a lot of things you can do wrong. It’s even more difficult when the IRS makes up their own rules for how they want your business’ tax deduction processed instead of following what the accounting industry has called guidelines on this subject (which is where all other accountants go).

The taxes on the income generated from depreciated assets are different from what is shown in company financial statements. Such a discrepancy arises because of depreciation. 

It’s usually lower for tax purposes, but higher on an accounting statement since it’s calculated over time instead of just once at purchase. At the end of life, there will be no deferred tax liability as they’re equal with both methods used to calculate depreciation.

The IRS Vs GAAP 

The Federal government’s Internal Revenue Services (IRS) is responsible for collecting taxes and administering statutory tax laws while following Generally Accepted Accounting Principles (GAAP). 

Although the IRS does not produce financial statements or other quantitative measures of a company’s income like most publicly traded companies do, it adheres to GAAP in order to report on its annual revenue.

The Internal Revenue Service and GAAP (Generally Accepted Accounting Principles) have different rules. This can lead to a difference in calculations, as well as the postponement of income tax payments.

Accounting methods and tax laws don’t always line up. Deferred income taxes are a prime example of this disparity because they occur when accounting treatments differ from those required by the IRS.

Treatment of Depreciation (IRS vs. GAAP)

IRS: – The IRS has established a setlist of depreciation methods for the treatment of assets, but some accountants might use alternate policies that are different from what is allowed by tax authorities. This can cause discrepancies in reporting as taxpayers must report which policy they used to calculate their deductions on taxes at year’s end.

GAAP: – GAAP allows them the freedom to choose a more flexible method. This means that while both methods may have similar depreciation schedules, they will vary considerably in their final net income figures and balance sheets.

Accountants follow GAAP to prepare financial statements, calculate taxes payable separately, and take advantage of any rules to reduce tax payments. These motivations can cause depreciation calculations for the year-end balance sheet statement to differ from those used during a typical accounting period when it comes time for paying federal income taxes in April.

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