Agreed-Upon Procedures

What Are Deferred Taxes?

Deferred taxes and the accompanying accounting rules for reporting these items can be very confusing to comprehend. Here’s a brief overview to help clarify the issue.

What Are Deferred Taxes?
Companies pay income tax on IRS-defined taxable income. On their Generally Accepted Accounting Principles (GAAP) financial statements, however, companies record income tax expense based on accounting ‘pretax net income.’ In a given year, taxable income (for federal income tax purposes) and pretax income (as reported on your GAAP income statement) may substantially differ. A common reason for this temporary difference is depreciation expense.

For income taxes, the IRS allows companies to use accelerated depreciation methods to lower the taxes paid in the early years of an asset’s useful life. Also, some companies may elect to claim Section 179 deductions and bonus depreciation in the year an asset is placed in service. Alternatively, for GAAP reporting purposes, companies frequently use straight-line depreciation. Early in an asset’s useful life, this divergent treatment usually causes taxable income to be significantly lower than GAAP pretax income. However, as the asset ages, the temporary difference in depreciation expense reverses itself.

The use of different depreciation methods for book and tax purposes causes a company to report deferred tax liabilities. That is, by claiming higher depreciation expense for tax purposes than for accounting purposes, the company has temporarily lowered its tax bill — but it will make up the difference in future tax years. Deferred tax assets may come from other sources, such as capital loss carryforwards, operating loss carryforwards, and tax credit carryforwards.

How Are Deferred Taxes Reported On The Financials?
If a company’s pretax income and its taxable income differ, it must record deferred taxes on its balance sheet. The company records a deferred tax asset for the future benefit it will receive if it pays the IRS more tax than an income statement reflects. If the opposite is true, the company records a deferred tax liability for the additional future amount it will owe.

Like other assets and liabilities, deferred taxes are classified as either current or long-term. Regardless of their classification, deferred taxes are recorded at their cash value (that is, no consideration of the time value of money). Deferred taxes also are based on current income tax rates. If tax rates change, the company may revise its balance sheet and the change flows through to the income statement.

While deferred tax liabilities are recorded at their full amount, deferred tax assets are offset by a valuation allowance that reflects the possibility the asset will expire before the company can use it. Deciding how much deferred tax valuation allowance to book is highly subjective and left to management’s discretion. Any changes to the allowance flow through to the company’s income statement.

Now Or Later?
Financial statement users can’t afford to lose sight of deferred taxes. All else being equal, a company with significant deferred tax assets may be able to lower its future tax bill and preserve its cash on hand by claiming deferred tax breaks. Conversely, a company with significant deferred tax liabilities has already tapped into tax breaks and may need additional cash on hand to pay Uncle Sam in future tax years. Contact us for more information.

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