How Tax Deferrals Work - dummies

By Maire Loughran

If a company has any sort of temporary difference, it has to report on its financial statements any deferred tax effect due to the temporary differences. So the company has to figure out the tax effect when book and taxable income catch up with each other and recognize the amount of tax that will be payable or refunded.

Two types of tax deferrals exist:

  • Deferred tax liability. Temporary differences that increase the amount of tax to be paid in future periods create a deferred tax liability. For example, say depreciation causes a temporary difference in book versus tax that results in book income tax expense of $25,000 and, under tax reporting, assesses the business income tax payable of $15,000.

    The difference between the two, $10,000 ($25,000 – $15,000), is the deferred tax dollar amount. Because income tax expense is more than income tax payable, the $10,000 is a deferred tax liability.

    It’s a liability because the $10,000 represents income taxes that will be payable in the future after the temporary depreciation difference evens out. The amount represents money the business will eventually owe to the government, so it is a liability.

  • Deferred tax asset. A deferred tax asset occurs when taxes payable in the future are less (or anticipated refunds are more) because of deductible temporary differences. Reversing the figures from the deferred tax liability example (income tax expense is $15,000 and income tax payable is $25,000), the $10,000 difference between the two figures is a deferred tax asset.

    It’s an asset because income tax payable will be less in the future after all temporary differences are reduced to zero, and the $10,000 will reduce the amount of tax payable to Uncle Sam.