What are Deferred Income Taxes?

Deferred income taxes are taxes that a company will eventually pay on its taxable income, but which are not yet due for payment. The difference in the amount of tax reported and paid is caused by differences in the calculation of taxes in the local tax regulations and in the accounting framework that a company uses. Given this difference, the organization’s income tax payable may not match the total income tax expense that it is reporting on its income statement. Examples of major accounting frameworks are Generally Accepted Accounting Principles and International Financial Reporting Standards.

Characteristics of Deferred Income Taxes

Below are the key characteristics of deferred income taxes:

Temporary differences. Deferred taxes originate from differences that are temporary, meaning they will reverse over time. These differences result in taxable or deductible amounts in future periods.
Classified as an asset or liability. Deferred tax assets (DTAs) represent future tax benefits due to deductible temporary differences or carryforwards of unused tax losses or credits. Deferred tax liabilities (DTLs) represent future tax obligations due to taxable temporary differences.
Recognition. Deferred income taxes are recognized in accordance with accounting standards like IFRS (IAS 12) or U.S. GAAP (ASC 740). It is only recognized if it is probable that sufficient future taxable profit will be available to utilize DTAs.
Reversal over time. Temporary differences reverse in future periods, causing DTAs or DTLs to reduce or increase future taxable income.
Impact on financial statements. Deferred income taxes appear in the balance sheet as a non-current asset or liability. They also affect the income tax expense reported in the income statement.
Originating sources. Taxable temporary differences result in deferred tax liabilities (e.g., accelerated depreciation for tax purposes), while deductible temporary differences result in deferred tax assets (e.g., warranty provisions or accrued expenses not yet deductible for tax purposes).
Measurement. Measured based on the tax rates that are expected to apply when the temporary differences reverse, using enacted or substantively enacted tax rates.
Valuation allowance. A valuation allowance may be required under U.S. GAAP to reduce the carrying amount of a DTA if it is more likely than not that the DTA will not be realized.
Tax rate changes. Changes in tax rates or laws can affect the value of DTAs and DTLs, leading to adjustments in the financial statements.
Not related to permanent differences. Deferred income taxes do not arise from permanent differences (e.g., expenses that are non-deductible for tax purposes or income that is tax-exempt).
Offsetting. In most cases, DTAs and DTLs are offset in the financial statements if they are related to the same tax jurisdiction and entity.

Accounting for Deferred Income Taxes

Any taxes that are payable under the relevant accounting framework, but which are not yet payable under local tax regulations are recorded as a tax liability on a company's balance sheet until such time as they are paid. The tax liability is frequently recorded as a long-term liability in the balance sheet, since there is usually no expectation of paying it within the next 12 months. This means that the deferred income taxes line item generally does not impact short-term liquidity ratios.

Example of Deferred Income Taxes

A company may use straight-line depreciation to record the depreciation on its fixed assets, but is allowed by tax regulations to use an accelerated depreciation method in its tax return. The result is less taxable income reported on the corporate tax return, which is caused by the increased amount of depreciation expense in the current period. Thus, the company pays fewer income taxes in the current period, even though a higher income tax is indicated in its normal income statement. In later years, when the amount of straight-line depreciation recognized catches up with the amount of accelerated depreciation, the amount of deferred income taxes related to this item will be reduced to zero.