Deferred Taxes Are Non Cash Taxes In The Current Period

Deferred taxes represent a fascinating and often misunderstood aspect of financial accounting. They arise from temporary differences between a company's accounting profit and its taxable income, leading to future tax obligations or benefits that are not recognized as cash transactions in the current period. Understanding deferred taxes is crucial for investors, analysts, and anyone seeking a deeper insight into a company’s financial health and future tax liabilities.

Understanding the Basics of Deferred Taxes

Deferred taxes occur because accounting rules (typically GAAP or IFRS) and tax regulations often differ in how they recognize revenues and expenses. These differences create temporary gaps between the book value of an asset or liability and its tax base.

• Accounting Profit vs. Taxable Income: Accounting profit is calculated following accounting standards, while taxable income is determined by tax laws.
• Temporary Differences: These are differences that will eventually reverse in future periods.
• Taxable Temporary Differences: These create future taxable amounts, leading to deferred tax liabilities.
• Deductible Temporary Differences: These create future deductible amounts, leading to deferred tax assets.

Deferred Tax Liabilities Explained

A deferred tax liability (DTL) represents the increase in taxes payable in future periods due to taxable temporary differences. These differences mean that a company has reported higher accounting profit compared to taxable income, resulting in an obligation to pay more taxes later.

Common Causes of Deferred Tax Liabilities

1. Accelerated Depreciation: Companies often use accelerated depreciation methods (like double-declining balance) for tax purposes, which allows them to deduct more depreciation expense in the early years of an asset's life. However, they might use straight-line depreciation for financial reporting. This creates a taxable temporary difference because the tax base of the asset is lower than its book value.

   Example: A company buys equipment for $1,000, depreciating it at $200 per year for five years using straight-line depreciation for accounting. For tax, it uses accelerated depreciation, deducting $400 in the first year.

   • Accounting: Depreciation expense is $200.
   • Tax: Depreciation expense is $400.

   This creates a taxable temporary difference of $200 ($400 - $200), leading to a deferred tax liability.

2. Installment Sales: Revenue from installment sales may be recognized immediately for accounting purposes but deferred for tax purposes until cash is collected.

3. Unrealized Gains: Unrealized gains on investments reported on the financial statements but not yet taxed create a deferred tax liability.

4. Prepaid Expenses: If expenses are prepaid but not yet deductible for tax purposes, this can also create a deferred tax liability.

Impact on Financial Statements

Deferred tax liabilities are reported on the balance sheet as non-current liabilities. They signify a future tax obligation, which can affect a company’s financial ratios and overall financial health.

• Balance Sheet: DTLs increase total liabilities.
• Income Statement: Changes in DTLs are reflected as part of the income tax expense.

Deferred Tax Assets Explained

A deferred tax asset (DTA) represents the reduction in taxes payable in future periods due to deductible temporary differences. These differences mean that a company has reported lower accounting profit compared to taxable income, resulting in a potential benefit to pay fewer taxes later.

Common Causes of Deferred Tax Assets

1. Accrued Expenses: Expenses that are recognized for accounting purposes but not yet deductible for tax purposes (e.g., warranty expenses) create a deductible temporary difference.

   Example: A company provides a warranty on its products, estimating warranty expenses of $50,000.

   • Accounting: Warranty expense is recognized immediately.
   • Tax: Warranty expense is deductible when the actual expense is incurred.

   This creates a deductible temporary difference of $50,000, leading to a deferred tax asset.

2. Net Operating Losses (NOLs): When a company incurs a loss, it can often carry that loss forward to offset future taxable income, creating a deferred tax asset.

3. Unrealized Losses: Unrealized losses on investments reported on the financial statements but not yet deductible for tax purposes create a deferred tax asset.

4. Deferred Revenue: If revenue is deferred for accounting purposes but recognized for tax purposes, this can also create a deferred tax asset.

Valuation Allowance

Deferred tax assets are subject to a valuation allowance. A valuation allowance is a contra-asset account that reduces the carrying value of a DTA if it is more likely than not that some portion or all of the deferred tax asset will not be realized.

• Assessment: Companies must assess the likelihood of realizing the benefit of the DTA based on factors like future profitability, taxable income, and tax planning strategies.
• Impact: A valuation allowance decreases the DTA, reducing the reported asset and increasing income tax expense.

Deferred Taxes as Non-Cash Taxes

One of the key characteristics of deferred taxes is that they are non-cash in the current period. This means that the recognition of deferred tax assets and liabilities does not involve an actual cash inflow or outflow at the time of recognition. Instead, they represent future tax consequences of past events.

Why Are Deferred Taxes Non-Cash?

1. Temporary Differences: Deferred taxes arise from temporary differences that will reverse in future periods. The actual cash payment or receipt of taxes will occur when these differences reverse.
2. Accrual Accounting: Deferred taxes are a product of accrual accounting, which recognizes revenues and expenses when they are earned or incurred, regardless of when cash changes hands.
3. Future Obligations/Benefits: Deferred tax liabilities represent future tax obligations, while deferred tax assets represent future tax benefits. The cash impact occurs when these obligations are settled or benefits are realized.

Impact on Cash Flow Statement

Because deferred taxes are non-cash, they are adjusted in the cash flow statement to reconcile net income to cash from operations.

• Indirect Method: Under the indirect method, changes in deferred tax assets and liabilities are added back to or subtracted from net income to arrive at cash from operations.
• Direct Method: Under the direct method, the actual cash paid for taxes is reported, and deferred taxes do not directly affect the cash flow from operations section.

Example of Non-Cash Impact

Consider a company that uses accelerated depreciation for tax purposes and straight-line depreciation for accounting. In the first year, the company reports a taxable temporary difference of $200, leading to a deferred tax liability.

• Accounting: Income tax expense includes both the current tax liability and the change in the deferred tax liability.
• Cash Flow: The actual cash paid for taxes is based on the taxable income, not the accounting profit. The change in the deferred tax liability is adjusted in the cash flow statement to reflect the non-cash nature of the deferred tax expense.

In future years, as the temporary difference reverses, the deferred tax liability will decrease, and the company will pay more in taxes. However, at the time of the initial deferred tax liability recognition, there is no cash outflow.

Accounting for Deferred Taxes: A Step-by-Step Approach

Accounting for deferred taxes involves a systematic approach to identify, measure, and recognize deferred tax assets and liabilities.

Step 1: Identify Temporary Differences

The first step is to identify all temporary differences between the book value of assets and liabilities and their tax bases.

• Book Value: The value of an asset or liability as reported on the balance sheet.
• Tax Base: The value of an asset or liability for tax purposes.

Step 2: Determine Taxable or Deductible Temporary Differences

Once temporary differences are identified, determine whether they are taxable or deductible.

• Taxable Temporary Differences: These will result in taxable amounts in future periods.
• Deductible Temporary Differences: These will result in deductible amounts in future periods.

Step 3: Calculate Deferred Tax Assets and Liabilities

Calculate the deferred tax assets and liabilities by multiplying the temporary differences by the applicable tax rate.

• Deferred Tax Liability: Taxable Temporary Difference × Future Tax Rate
• Deferred Tax Asset: Deductible Temporary Difference × Future Tax Rate

The future tax rate is the rate expected to apply when the temporary differences reverse.

Step 4: Evaluate the Need for a Valuation Allowance

Assess the likelihood of realizing the benefit of deferred tax assets. If it is more likely than not that some portion or all of the DTA will not be realized, a valuation allowance should be recorded.

Step 5: Record Deferred Tax Assets and Liabilities

Record the deferred tax assets and liabilities on the balance sheet. The change in deferred tax assets and liabilities is recognized as part of the income tax expense on the income statement.

Step 6: Disclose in Financial Statements

Disclose information about deferred tax assets and liabilities in the notes to the financial statements. This includes the nature of the temporary differences, the amounts of deferred tax assets and liabilities, and any valuation allowances.

Impact of Tax Law Changes on Deferred Taxes

Changes in tax laws can significantly impact deferred tax assets and liabilities. When tax rates change, companies must re-measure their deferred tax assets and liabilities to reflect the new rates.

• Tax Rate Increase: An increase in the tax rate will increase deferred tax liabilities and deferred tax assets.
• Tax Rate Decrease: A decrease in the tax rate will decrease deferred tax liabilities and deferred tax assets.

The impact of tax law changes is recognized in the period the changes are enacted.

Example: Impact of a Tax Rate Change

Assume a company has a deferred tax liability of $100,000 and a deferred tax asset of $50,000 when the tax rate is 30%. If the tax rate increases to 35%, the deferred tax liability will increase to $116,667 ($100,000 × 35%/30%), and the deferred tax asset will increase to $58,333 ($50,000 × 35%/30%).

This adjustment affects the income tax expense in the period of the tax rate change.

Real-World Examples of Deferred Taxes

To further illustrate the concept of deferred taxes, let’s look at some real-world examples:

1. Technology Company: A technology company uses accelerated depreciation for tax purposes and straight-line depreciation for financial reporting. This results in a deferred tax liability that reflects the future tax obligations when the accelerated depreciation benefits reverse.
2. Retail Company: A retail company offers warranties on its products. The estimated warranty expenses are recognized for accounting purposes but are deductible for tax purposes only when the actual expenses are incurred. This creates a deferred tax asset.
3. Manufacturing Company: A manufacturing company has net operating losses that it can carry forward to offset future taxable income. These NOLs create a deferred tax asset.
4. Real Estate Company: A real estate company has unrealized gains on investment properties that are recognized for accounting purposes but not taxed until the properties are sold. This results in a deferred tax liability.

The Importance of Understanding Deferred Taxes

Understanding deferred taxes is crucial for several reasons:

1. Financial Analysis: Deferred taxes provide insights into a company’s future tax obligations and potential tax benefits. Analyzing deferred tax assets and liabilities can help investors and analysts assess the quality of earnings and the sustainability of a company’s financial performance.
2. Investment Decisions: Deferred taxes can affect a company’s financial ratios and overall financial health. Investors should consider deferred taxes when making investment decisions.
3. Tax Planning: Companies can use deferred tax assets and liabilities to manage their tax obligations and optimize their tax strategies.
4. Regulatory Compliance: Accurate accounting for deferred taxes is essential for compliance with accounting standards and tax regulations.

Common Misconceptions About Deferred Taxes

1. Deferred Taxes Are Always Bad: While deferred tax liabilities represent future tax obligations, deferred tax assets can be beneficial. Both should be evaluated in the context of a company’s overall financial situation.
2. Deferred Taxes Are Always Non-Cash: While the recognition of deferred taxes is non-cash, the actual payment or receipt of taxes in future periods will involve cash.
3. Deferred Taxes Are Not Important: Deferred taxes can have a significant impact on a company’s financial statements and should not be overlooked.
4. Deferred Taxes Are Easy to Understand: Deferred taxes can be complex and require a thorough understanding of accounting standards and tax regulations.

Conclusion

Deferred taxes are an essential aspect of financial accounting, arising from temporary differences between accounting profit and taxable income. As non-cash taxes in the current period, they represent future tax obligations (deferred tax liabilities) or potential tax benefits (deferred tax assets). Understanding how deferred taxes are created, measured, and recognized is crucial for assessing a company’s financial health, making informed investment decisions, and ensuring regulatory compliance. By carefully analyzing deferred tax assets and liabilities, stakeholders can gain valuable insights into a company’s future tax position and overall financial performance.