Deferred taxes are often one of the more misunderstood areas of financial reporting. In general, deferred tax assets and liabilities reflect temporary differences between when income, expenses, assets, or liabilities are recognized for financial reporting purposes and when they are recognized for tax purposes. Understanding these differences can help business owners, management teams, lenders, and other stakeholders better interpret the financial statements.

Who Must Report Deferred Taxes?

Not every business reports deferred taxes. The accounting rules for deferred taxes generally apply to businesses subject to entity-level income taxes that prepare financial statements under U.S. Generally Accepted Accounting Principles (GAAP). Many S corporations, partnerships, and other pass-through entities don’t record federal income taxes at the entity level, though exceptions may apply. Small businesses that use the cash or tax basis of accounting don’t usually report deferred taxes either.

C corporations and other businesses subject to entity-level income taxes pay tax on “taxable income” as determined under applicable tax law. However, for GAAP purposes, total income tax expense generally includes 1) current tax expense or benefit, reflecting taxes payable or refundable for the current year, and 2)  deferred tax expense or benefit for changes in deferred tax assets and liabilities.

Where Do Deferred Taxes Come From?

Each year, taxable income and pretax book income may differ. A common reason for a temporary difference is depreciation expense. For federal income tax purposes, businesses may be able to use accelerated depreciation methods to reduce taxable income in the early years of an asset’s useful life. Some businesses also may elect to claim Section 179 deductions and bonus depreciation in the year an asset is placed in service.

For GAAP reporting purposes, businesses frequently use straight-line depreciation. Early in an asset’s useful life, this divergent treatment usually makes taxable income significantly lower than accounting pretax income. However, as the asset ages, the temporary difference in depreciation expense reverses itself.

Using different depreciation methods for book and tax purposes typically causes a business to report a deferred tax liability. In effect, the business pays less tax today because it claims larger depreciation deductions upfront. However, those deductions won’t be available later, resulting in higher taxable income in future years.

Depreciation is just one type of accounting event that may give rise to deferred tax items. Other common examples include certain loss contingencies, charitable contribution carryforwards, and accounting estimates (such as warranty costs and allowances for credit losses).

It’s important to distinguish temporary differences from permanent differences. Temporary differences reverse over time and create deferred taxes. Permanent differences, such as certain nondeductible expenses or tax-exempt income, may affect the business’ effective tax rate but don’t result in deferred tax assets or liabilities.

How Are Deferred Taxes Reported On The Balance Sheet?

When temporary differences exist between taxable income and accounting pretax income, your business generally must record deferred tax assets, deferred tax liabilities, or both on its balance sheet. You must record deferred tax assets for expected future tax benefits from deductible temporary differences and from carryforwards related to capital losses, net operating losses, or tax credits. Conversely, you must record deferred tax liabilities for the additional future amounts your business will owe.

Deferred tax assets and liabilities are measured using enacted tax rates expected to apply when the related temporary differences reverse, or carryforwards are used. Because deferred taxes reflect future tax consequences, changes in tax law or tax rates can affect their reported amounts, with the impact generally recognized in income from continuing operations in the period of enactment.

Under GAAP, deferred tax assets and liabilities are generally presented as noncurrent items on the balance sheet. They may be netted only when they relate to the same tax-paying component and tax jurisdiction.

Deferred taxes also aren’t discounted for the time value of money. Instead, they’re recorded based on the applicable tax rate and the expected future tax effects of temporary differences.

Deferred tax assets may be reduced by a valuation allowance that reflects the possibility they’ll expire before the business can use them. Management must evaluate all available positive and negative evidence when determining whether a valuation allowance is necessary. Deciding how much deferred tax valuation allowance to book requires significant judgment and is often one of the more challenging aspects of income tax accounting. Changes in the allowance generally flow through to the income statement.

Look Beyond Today’s Tax Bill

The rules surrounding deferred taxes can be complex, but understanding them is important for maintaining accurate financial statements. Because deferred tax balances may affect both the income statement and balance sheet, they may also impact ratios that lenders and other external stakeholders use to evaluate your business’ financial results. We can help you account for deferred taxes and explain what they mean for your business. Contact us to learn more.