Deferred tax accounting is a complex area of financial reporting that reflects the future tax effects of transactions already recognized in an entity’s financial statements or tax returns. Under Accounting Standards Codification Topic 740, Income Taxes (ASC 740), deferred tax assets and liabilities generally arise from temporary differences between the financial statement carrying amounts of assets and liabilities and their corresponding tax bases, as well as from certain tax loss and credit carryforwards.

Understanding these differences is important because deferred tax balances can affect an entity’s income tax expense, net income, balance sheet presentation, financial ratios, and related financial statement disclosures.

Which Entities Are Subject to Deferred Tax Accounting?

ASC 740 generally applies to entities subject to income taxes that prepare financial statements in accordance with U.S. generally accepted accounting principles, or U.S. GAAP.

C corporations and other taxable entities generally recognize the effects of income taxes at the entity level. For these entities, total income tax expense or benefit ordinarily includes:

1. Current tax expense or benefit, representing income taxes payable or refundable for the current reporting period; and
2. Deferred tax expense or benefit, representing the change in deferred tax assets and liabilities during the reporting period.

Many S corporations, partnerships, limited liability companies, and other pass-through entities generally do not recognize federal income taxes at the entity level because taxable income or loss passes through to their owners. However, exceptions may apply, including circumstances involving state, local, foreign, franchise, or entity-level taxes.

Entities preparing financial statements on the cash basis, income tax basis, or another special-purpose framework may not apply the deferred tax accounting requirements of U.S. GAAP. The appropriate treatment depends on the applicable financial reporting framework and the entity’s specific facts and circumstances.

What Causes Deferred Taxes?

Deferred taxes generally result from differences between pretax financial income reported under U.S. GAAP and taxable income determined under applicable tax law.

Some differences are temporary and are expected to reverse in future periods. Others are permanent and do not reverse.

Depreciation as a Common Temporary Difference

Depreciation is one of the most common sources of temporary differences.

For federal income tax purposes, an entity may be permitted to use accelerated cost-recovery methods or claim deductions under Internal Revenue Code Section 179 or applicable bonus depreciation provisions. Eligibility, limitations, and available deductions depend on the tax law in effect and the taxpayer’s circumstances.

For financial reporting purposes, an entity may use straight-line depreciation or another systematic method that reflects the pattern in which the asset’s economic benefits are consumed.

When tax depreciation exceeds book depreciation during the earlier years of an asset’s useful life, taxable income may initially be lower than pretax book income. The difference generally reverses in later periods as tax deductions decline or are exhausted.

Subject to the applicable provisions of ASC 740, this difference typically results in a deferred tax liability because the entity has reduced its current taxable income but may recognize higher taxable income in future periods as the temporary difference reverses.

Other Sources of Deferred Tax Assets and Liabilities

Temporary differences and carryforwards may arise from several types of transactions, including:

• Accrued expenses that are not deductible until paid;
• Estimated warranty obligations;
• Allowances for credit losses;
• Certain loss contingencies;
• Deferred revenue;
• Differences in inventory accounting;
• Net operating loss carryforwards;
• Capital loss carryforwards;
• Charitable contribution carryforwards; and
• Federal, state, local, or foreign tax credit carryforwards.

The classification and measurement of each item depend on the relevant accounting guidance, applicable tax law, available elections, and the entity’s particular facts and circumstances.

Temporary Differences vs. Permanent Differences

Distinguishing between temporary and permanent differences is fundamental to deferred tax accounting.

Temporary Differences

Temporary differences generally arise when the financial statement carrying amount of an asset or liability differs from its tax basis and the difference is expected to result in taxable or deductible amounts in future periods.

Temporary differences may create:

• A deferred tax asset when the difference is expected to produce a future tax benefit; or
• A deferred tax liability when the difference is expected to produce a future taxable amount.

Permanent Differences

Permanent differences affect pretax book income or taxable income but do not reverse in a future period. Examples may include certain nondeductible expenses and tax-exempt income.

Permanent differences do not create deferred tax assets or liabilities. However, they may affect an entity’s effective income tax rate and related financial statement disclosures.

How Are Deferred Taxes Measured?

Deferred tax assets and liabilities are generally measured using enacted tax rates expected to apply during the periods in which temporary differences are expected to reverse or carryforwards are expected to be realized.

Changes in enacted tax laws or rates may require an entity to remeasure its existing deferred tax balances. The resulting adjustment is generally recognized in the period that includes the enactment date, although the applicable financial statement classification depends on the relevant accounting guidance and underlying transaction.

Deferred tax balances are not discounted to reflect the time value of money.

Because tax laws and rates may vary among jurisdictions, entities must evaluate deferred taxes separately for each applicable tax-paying component and tax jurisdiction.

Balance Sheet Presentation

When an entity presents a classified balance sheet under U.S. GAAP, deferred tax assets and liabilities, including any related valuation allowance, are generally classified as noncurrent. [viewpoint.pwc.com]

Deferred tax assets and liabilities may be offset only when they relate to the same tax-paying component and the same tax jurisdiction. Deferred tax balances associated with different jurisdictions generally may not be netted against one another. [viewpoint.pwc.com]

ASC 740 also includes disclosure requirements relating to deferred tax assets, deferred tax liabilities, valuation allowances, significant temporary differences, and certain carryforwards. The required disclosures may differ depending on the nature of the entity and its reporting obligations.

Valuation Allowances for Deferred Tax Assets

Recognition of a deferred tax asset does not necessarily mean the entire benefit will ultimately be realized.

Management must evaluate the available positive and negative evidence to determine whether it is more likely than not that some portion or all of a deferred tax asset will not be realized. If realization does not meet the applicable recognition threshold, a valuation allowance is required to reduce the deferred tax asset to the amount expected to be realized.

This evaluation may include consideration of:

• Historical taxable income or losses;
• Expected future taxable income;
• Existing taxable temporary differences;
• Tax loss and credit carryforward periods;
• Limitations on the use of carryforwards; and
• Qualifying tax-planning strategies.

The valuation allowance assessment requires significant professional judgment and should be supported by appropriate analysis and documentation. Changes in facts, forecasts, tax laws, or business conditions may require the allowance to be reassessed in subsequent reporting periods.

Why Deferred Taxes Matter

Deferred taxes extend beyond the calculation of an entity’s current tax liability. They reflect the expected future tax consequences of transactions recognized for financial reporting purposes.

Deferred tax balances may affect:

• Income tax expense or benefit;
• Net income;
• Total assets and liabilities;
• Effective tax rate calculations;
• Debt covenant and financial ratio calculations;
• Forecasting and budgeting; and
• Disclosures provided to lenders, investors, owners, and other financial statement users.

Errors in identifying, measuring, or presenting deferred tax balances may result in inaccurate financial statements or incomplete disclosures. Entities should therefore maintain appropriate supporting schedules, evaluate changes in tax law, and reassess significant estimates and judgments at each reporting date.

Look Beyond the Current Tax Liability

Deferred tax accounting requires an understanding of both financial reporting standards and applicable tax law. The analysis is highly dependent on the entity’s structure, tax jurisdictions, temporary differences, available carryforwards, projected taxable income, and other relevant facts.

Careful evaluation can help management prepare accurate financial statements and communicate the future tax consequences of current transactions to lenders, owners, and other stakeholders.

TRP Sumner PLLC can assist businesses with evaluating deferred tax assets and liabilities, assessing valuation allowances, and addressing the related financial reporting and disclosure considerations.

Contact TRP Sumner

This article is intended for general informational and educational purposes only. It does not constitute accounting, tax, legal, investment, or other professional advice and should not be relied upon as a substitute for advice based on a reader’s specific circumstances.

Accounting standards, tax laws, regulations, and administrative guidance are subject to change, and their application may vary based on the relevant facts, tax jurisdiction, and reporting framework. Examples in this article are simplified for explanatory purposes and may not address all recognition, measurement, presentation, disclosure, or tax compliance considerations. Readers should consult qualified accounting, tax, and legal professionals before making decisions or taking action.