Deferred tax expense is the amount of income tax that a business owes but has not paid yet. It arises when there is a difference between the accounting methods used for financial reporting and tax purposes. This difference can affect the timing and amount of income and expenses that are recognized in the financial statements and the tax returns.
In this blog post, you will learn:
- What causes deferred tax expense
- How to calculate deferred tax expense
- How deferred tax expense impacts your financial statements and cash flow
- How to reduce deferred tax expense and optimize your tax planning
What Causes Deferred Tax Expense?
Deferred tax expense is caused by temporary or permanent differences between the book income and the taxable income of a business. Book income is the income that is reported in the financial statements, while taxable income is the income that is subject to tax according to the tax laws.
Temporary differences are differences that reverse over time, meaning that they affect the book income and the taxable income in different periods. For example, depreciation is a common source of temporary difference. Depreciation is the allocation of the cost of a fixed asset over its useful life. Different methods of depreciation can be used for financial reporting and tax purposes, resulting in different amounts of depreciation expense in each period. This creates a temporary difference between the book income and the taxable income, which leads to deferred tax expense.
Permanent differences are differences that do not reverse over time, meaning that they affect the book income and the taxable income in the same period but with different amounts. For example, fines and penalties are a common source of permanent difference. Fines and penalties are expenses that are deductible for book purposes but not for tax purposes. This creates a permanent difference between the book income and the taxable income, which also leads to deferred tax expense.
How to Calculate Deferred Tax Expense?
Deferred tax expense is calculated by multiplying the temporary difference by the tax rate. For example, if a business has a book income of $100,000 and a taxable income of $80,000, and the tax rate is 25%, the deferred tax expense is:
Deferred tax expense = ($100,000 – $80,000) x 25% = $5,000
The deferred tax expense is recorded as a liability on the balance sheet, called deferred tax liability. This liability represents the amount of tax that the business will have to pay in the future when the temporary difference reverses.
Alternatively, if the taxable income is higher than the book income, the deferred tax expense is negative, meaning that the business has paid more tax than it owes. This creates a deferred tax asset on the balance sheet, which represents the amount of tax that the business will save in the future when the temporary difference reverses.
How Deferred Tax Expense Impacts Your Financial Statements and Cash Flow?
Deferred tax expense affects the income statement, the balance sheet, and the cash flow statement of a business. On the income statement, deferred tax expense is subtracted from the pre-tax income to arrive at the net income. This reduces the profitability of the business in the current period.
On the balance sheet, deferred tax expense increases the deferred tax liability or decreases the deferred tax asset, depending on the sign of the expense. This affects the solvency and liquidity of the business, as it represents a future obligation or benefit.
On the cash flow statement, deferred tax expense is added back to the net income in the operating cash flow section, as it is a non-cash expense. This increases the cash flow from operations, which reflects the cash-generating ability of the business.
How to Reduce Deferred Tax Expense and Optimize Your Tax Planning?
Deferred tax expense can be reduced by minimizing the temporary and permanent differences between the book income and the taxable income. This can be done by:
- Choosing the same accounting methods for financial reporting and tax purposes, such as the same depreciation method, inventory valuation method, revenue recognition method, etc.
- Avoiding transactions that create permanent differences, such as fines, penalties, non-deductible expenses, tax-exempt income, etc.
- Taking advantage of tax credits, deductions, and incentives that reduce taxable income, such as research and development credits, charitable donations, capital allowances, etc.
Conclusion
Deferred tax expense is a complex but important concept that affects the income tax, financial statements, and cash flow of a business. It is caused by temporary or permanent differences between the book income and the taxable income of a business, which can result from different accounting methods, transactions, or tax rules. Deferred tax expense can be reduced by minimizing these differences and taking advantage of tax benefits. By doing so, a business can lower its effective tax rate and increase its after-tax profitability and cash flow.
