Deferred tax arises from temporary differences between the accounting and tax treatments of certain income and expenses, resulting in deferred tax assets or liabilities on the balance sheet.
- Common examples include depreciation methods, inventory reserves, leases, stock compensation, which are recognized differently for book and tax purposes.
- Deferred tax assets represent amounts that are deductible in future years yet provide no current benefit, while deferred tax liabilities are future tax costs on income not yet reported.
- Each reporting period involves remeasuring net deferred tax balances using enacted tax rates expected to apply in the year the differences will reverse.
Example:
A technology company had deferred tax assets from stock options where the book expense exceeds the tax deduction taken only in the exercise year well into the future.
Takeaway:
Prudent recognition and measurement of deferred taxes provides crucial transparency regarding future tax effects embedded in financial statements and how they shift a company’s long-term tax profile over time.