Deferred Income Tax

A deferred income tax is a liability recorded on a balance sheet resulting from a difference in income recognition between tax laws and the company's accounting methods. For this reason, the company's payable income tax may not equate to the total tax expense reported. 

The total tax expense for a specific fiscal year may be different than the tax liability owed to the IRS as the company is postponing payment based on accounting rule differences.

Generally accepted accounting principles, known as GAAP, will guide financial accounting practices. GAAP accounting requires the calculation and disclosure of economic events in a specific manner. Income tax expense, which is a financial accounting record, is calculated using GAAP income. 

In contrast, the Internal Revenue Service (IRS) tax code specifies special rules on the treatment of events. The differences between IRS rules and GAAP guidelines result in different computations of net income, and subsequently, income taxes due on that income.

Situations may arise where the income tax payable on a tax return is higher than the income tax expense on a financial statement. In time, if no other reconciling events happen, the deferred income tax account would net to $0. 

However, without a deferred income tax liability account, a deferred income tax asset would be created. This account would represent the future economic benefit expected to be received because income taxes charged were in excess based on generally accepted accounting principles (GAAP) income.

The most common situation that generates a deferred income tax liability is from differences in depreciation methods. GAAP guidelines allow businesses to choose between multiple depreciation practices. However, the IRS requires the use of one depreciation method that is different from all the available GAAP methods. 

For this reason, the amount of depreciation recorded on a financial statement is usually different than the calculations found on a company’s tax return. Over the life of the asset, the value of the depreciation in both areas changes. At the end of the life of the asset, no deferred tax liability exists, as the total depreciation between the two methods is equal.

A deferred income tax liability results from the difference between the income tax expense reported on the income statement and the income tax payable, which is on the balance sheet.

A deferred income tax liability is classified on a balance sheet. It may be classified as either a short-term or current, liability or as a long-term liability. If the deferred tax liability is presumed to be paid in the next 12 months, it must be recorded as a current liability. Otherwise, it is of a long-term nature.