Deferred Income Tax

What is a Deferred Income Tax?

Deferred income tax is a liability that can be found on a balance sheet. It results from differences in income recognition between tax laws (IRS) and accounting methods (GAAPGAAPGAAP, Generally Accepted Accounting Principles, is a recognized set of rules and procedures that govern corporate accounting and financial reporting in the US.).

In financial reporting, a company’s income tax payableIncome Tax PayableIncome tax payable is a term given to a business organization’s tax liability to the government where it operates. The amount of liability will be based on its profitability during a given period and the applicable tax rates. Tax payable is not considered a long-term liability, but rather a current liability, must equate to total tax expense. However, income tax payable may not equal total tax expense due to the difference in income recognition between tax laws and accounting methods.

To simplify, accounting rule differences between a company and the IRS may cause a deferment in income tax payment.

The IRS vs. GAAP

The Internal Revenue Services (IRS) is a government agency that is primarily responsible for the collection of tax and administration of statutory tax laws. Generally Accepted Accounting Principles (GAAP) is a regularly followed set of accounting rules and principles that govern the standards for year-end financial reporting.

Consequently, the rules and principles within GAAP can sometimes differ from the rules and principles within the IRS. Such rule differences can cause strenuous reporting errors and the postponement of income tax payments.

In comparison, the most common difference between the IRS and GAAP is the methods used to designate deprecation. It is generally the main cause of deferred income tax.

Deferred income tax is mainly caused by differences in income recognition between tax laws (IRS) and accounting methods (GAAP). Listed below are the main characteristics of the IRS and GAAP to better understand how different they are.

IRS:

• Responsible for collecting taxes and making tax law
• Services the taxation of every American company
• Conducts numerous large-scale audits to ensure correct taxation
• A company is more likely to be audited by the IRS if it is a big business
• Scams are run by people claiming to be the IRS

GAAP:

• Accounting rules and principles
• Accountants follow GAAP when they compose financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are intricately
• S Public companies must follow GAAP rules and principles
• The primary focus is to ensure consistency, clarity, and comparability of financial statements issued by companies and individuals

To learn more about the treatment of deferred income taxes, check out CFI’s Reading Financial Statements Course!

Treatment of Depreciation (IRS vs. GAAP)

As mentioned, the main cause of deferred income tax is the treatment of depreciation. It is how there may be issues in depreciation recognition between the IRS and GAAP.

• IRS: The IRS allows a set list of depreciation methods for the treatment of depreciation on specific assets. It can cause reporting discrepancies when accountants choose to use other forms of depreciation that are different from the tax agency.
• GAAP: Unlike the IRS, GAAP gives accountants the freedom to select from multiple methods of deprecation. With this in mind, freedom in selection can potentially cause a wide variety of differences between the IRS and GAAP.

As a whole, accountants are more motivated to follow GAAP due to the direct relation to accounting. It can cause depreciation to be stated differently when tax season arrives.

MACRS – The IRS’s Depreciation System

Some of the methods used for depreciation by the IRS and GAAP are discussed below.

The modified accelerated cost recovery system (MACRS) is the primary tax depreciation system used by the IRS. It allows the capital cost of an asset to be recovered through annual deductions over a certain period. In addition, the IRS has a specific list of assets that are eligible for MACRS depreciation and assets that are not.

For example, MACRS depreciation can be used on assets, such as office furniture, buildings, and equipment. It cannot be used on assets such as intangible property, certain aged properties, and film/video recording.

Within the MACRS system, two distinct forms of depreciation are used – the straight-line methodStraight Line DepreciationStraight line depreciation is the most commonly used and easiest method for allocating depreciation of an asset. With the straight line method, the annual depreciation expense equals the cost of the asset minus the salvage value, divided by the useful life (# of years). This guide has examples, formulas, explanations and the declining balance method.

The IRS’s depreciation system limits accountants to two basic methods of depreciation. GAAP uses the two forms of depreciation stated above, but it also adds methods such as the sum of the year’s digits method and the units of production method.

As you may be able to tell, issues regarding deferred income tax arise when accountants use methods other than the straight-line method and the declining balance method.

More Resources

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™CBCA™ CertificationThe Certified Banking & Credit Analyst (CBCA)™ accreditation is a global standard for credit analysts that covers finance, accounting, credit analysis, cash flow analysis, covenant modeling, loan repayments, and more. certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Depreciation MethodsDepreciation MethodsThe most common types of depreciation methods include straight-line, double declining balance, units of production, and sum of years digits. There are various formulas for calculating depreciation of an asset. Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful life.
• IFRS vs. US GAAPIFRS vs. US GAAPThe IFRS vs US GAAP refers to two accounting standards and principles adhered to by countries in the world in relation to financial reporting. More than 110 countries follow the International Financial Reporting Standards (IFRS), which encourages uniformity in preparation of financial statements.
• Intangible AssetsIntangible AssetsAccording to the IFRS, intangible assets are identifiable, non-monetary assets without physical substance. Like all assets, intangible assets are those that are expected to generate economic returns for the company in the future. As a long-term asset, this expectation extends beyond one year.
• MACRS DepreciationMACRS DepreciationMACRS Depreciation is the tax depreciation system that is currently employed in the United States. The MACRS, which stands for Modified Accelerated Cost Recovery System, was originally known as the ACRS (Accelerated Cost Recovery System) before it was rebranded to its current form after the enactment of the Tax Reform Act in 1986.