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Deferred taxes explained

October 17, 2017

My last blog illustrated the effect of a lower corporate tax rate on the deferred taxes payable or receivable accounts. I received a few emails asking me to explain what a deferred tax actually is and how it comes about. Good questions, so here are explanations with examples.

Deferred taxes payable
The deferred tax payable arises when the income tax expense on the financial statement using GAAP rules is higher than the income taxes actually paid based on the profits reported on the tax return. In effect taxes were underpaid for GAAP and this will have to be made up in a later year (i.e. it is deferred); therefore they “owe” the taxes.

An example is when the company uses straight line depreciation on the financial statement and accelerated depreciation on the tax return. The straight line method results in equal deductions for every year of the asset’s useful life while the accelerated depreciation creates larger deductions in early years and lower deductions in later years. This strategy defers taxes to later years. At the end of the designated useful life of the asset [which must be the same for GAAP and tax] being depreciated, the same amounts would have been deducted.

Note that most companies want to report as high a profit as possible since it supports the stock price and creates greater book value for borrowing purposes; while no company wants to pay more taxes than necessary so they use permissible strategies that allow lower profits even if it is a temporary reduction.

Deferred taxes receivable
When the taxes on the tax return are higher than the GAAP taxes the company “overpaid” their current taxes and will get these back via paying lower taxes in the future, hence an asset.

An example is charitable contributions that are limited for tax purposes but not limited for GAAP. In that case the company will eventually get the deduction for the unused charitable contributions which can be carried forward on the tax return. Therefore the future tax deductions create an asset for the taxes that will be saved.

Another example creating a deferred asset could be a tax loss that can be carried forward to offset future years’ profits. To the extent this can be deducted in full on the financial statement, but not on the tax return, it becomes an asset for tax purposes that will reduce taxes in a later year, i.e. a deferred asset.

Timing differences
All deferred taxes are the result of timing differences. There are other differences that are not timing differences but inherent in the differences between the two systems, and those do not factor into the deferred taxes.

Hopefully the above sheds some light on this confusing area.

One Comment leave one →
  1. 6hawthorne permalink
    October 17, 2017 5:45 am

    Hi ED I would like to defer every thing to the future and let some handle it bob

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