Deferred income tax is the amount of income tax that a company has postponed paying to a future period. It arises when there is a difference between the accounting and tax treatment of an item, resulting in a temporary difference in taxable income. To calculate deferred income tax, the company multiplies the temporary difference by the applicable tax rate in the period in which the difference occurs. This amount is recorded as a liability on the balance sheet and represents the tax that will eventually be payable when the temporary difference reverses.
Liability Calculation
The calculation of deferred income tax liability involves the following steps:
- Determine the timing difference between financial and tax reporting.
- Multiply the timing difference by the applicable tax rate.
- The resulting amount is the deferred income tax liability.
For example, consider a company with a timing difference of $100,000 and a tax rate of 30%. The deferred income tax liability would be calculated as follows:
- Timing difference: $100,000
- Tax rate: 30%
- Deferred income tax liability: $100,000 x 30% = $30,000
| Timing Difference | Tax Rate | Deferred Income Tax Liability |
|---|---|---|
| $100,000 | 30% | $30,000 |
Temporary Differences
Temporary differences are differences between the financial reporting and tax reporting of income or expenses. These differences can be caused by different accounting methods being used for financial reporting and tax purposes, or by different timing of recognition of income or expenses.
Temporary differences can be classified as either positive or negative. A positive temporary difference is one that causes taxable income to be lower than financial reporting income, while a negative temporary difference is one that causes taxable income to be higher than financial reporting income.
Temporary differences are important because they can result in deferred income taxes. Deferred income taxes are taxes that are owed on income that has been recognized for financial reporting purposes, but has not yet been recognized for tax purposes.
The amount of deferred income taxes is calculated using the following formula:
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Deferred income taxes = Temporary differences x Tax rate
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For example, if a company has a positive temporary difference of $100,000 and a tax rate of 30%, the amount of deferred income taxes would be $30,000.
Deferred income taxes are recorded as a liability on the company’s financial statements. This liability represents the amount of taxes that the company will owe in the future when the temporary differences reverse.
The following table summarizes the key steps involved in calculating deferred income taxes:
| Step | Description |
|—|—|
| 1 | Identify the temporary differences between financial reporting income and taxable income. |
| 2 | Classify the temporary differences as either positive or negative. |
| 3 | Calculate the amount of deferred income taxes using the following formula: **Deferred income taxes = Temporary differences x Tax rate** |
| 4 | Record the deferred income taxes as a liability on the company’s financial statements. |
Deferred Income Tax Calculation
Deferred income tax is calculated by comparing the company’s financial income to its taxable income. Financial income is calculated according to Generally Accepted Accounting Principles (GAAP), while taxable income is calculated according to the tax code. These two income figures may differ due to timing, deductions, and other factors.
The difference between financial income and taxable income results in taxable temporary differences (TTDs). TTDs can be positive or negative and represent items that will be taxed or deducted in future years.
Deferred income tax is then calculated by multiplying the TTDs by the applicable tax rate. The result is the amount of income tax that will be paid or refunded in future years.
Reversal of Deferred Income Tax
Deferred income tax is reversed when the TTDs reverse. This can occur when the assets or liabilities that created the TTDs are sold or disposed of. The reversal of deferred income tax can result in a gain or loss on the income statement.
Example
Consider a company that purchased a new building and depreciated it over a 10-year period for financial reporting purposes. For tax purposes, the company was able to depreciate the building over a 5-year period. This created a positive TTD of $50,000.
The company’s tax rate is 25%. Therefore, the deferred income tax liability is $50,000 * 25% = $12,500.
When the building is sold, the TTD will reverse. This will result in a reduction of the deferred income tax liability by $12,500. The company will also recognize a gain on the sale of the building of $12,500.
| Year | Financial Income | Taxable Income | TTD | Deferred Income Tax |
|---|---|---|---|---|
| 1 | 100,000 | 80,000 | 20,000 | 5,000 |
| 2 | 120,000 | 90,000 | 30,000 | 7,500 |
| 3 | 150,000 | 120,000 | 30,000 | 7,500 |
There you have it, my friend! Figuring out deferred income tax may seem like a brain-teaser at first, but once you break it down step by step, it’s a piece of cake. Remember, accounting is all about connecting the dots and getting a clear picture of a company’s financial health. If you need to brush up on this topic again, don’t hesitate to swing by and say hello. We’re always happy to help you out!