Understanding Deferred Income Tax: A Comprehensive Guide

Deferred income tax is a liability that can be found on a balance sheet. It results from differences in income tax 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).

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.

Summary

• Deferred income tax is a liability. It primarily arises from differences in taxes payable created by different depreciation methods.
• It is directly related to differences in income recognition between tax laws (IRS) and accounting methods (GAAP).
• The IRS follows the MACRS depreciation system that includes the straight-line method and the declining balance method.
• Accountants not using the MACRS depreciation system may run into income tax treatment issues causing income tax to be deferred.

The IRS vs. GAAP

The Internal Revenue Services (IRS) is a government agency primarily responsible for collecting taxes and administering statutory tax laws. Generally Accepted Accounting Principles (GAAP) regularly follows a 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 differences in calculations and the postponement of income tax payments.

For example, the most common difference between the IRS and GAAP is the methods used to calculate depreciation.

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 tax return processing
• Provide taxpayer services to individuals and  companies
• Conducts audits and investigations and ensures taxation enforcement
• A company is more likely to be audited by the IRS if it is a complex business

GAAP:

• Accounting rules and principles
• Accountants follow GAAP when they prepare 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
• 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)

The main cause of deferred income tax is due to the differences between how depreciation is calculated under 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 alternate depreciation policies that are different from the tax agency.
• GAAP: Unlike the IRS, GAAP gives accountants the freedom to select from multiple methods of depreciation. With this in mind, freedom in selection can potentially cause a wide variety of differences between the IRS and GAAP.

As a whole, accountants will follow GAAP to prepare financial statements, calculate taxes payable separately, and take advantage of any rules to reduce taxes payable. These motivations 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 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. Also, 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 intangible property, certain aged properties, and film/video recording.

Within the MACRS system, two distinct forms of depreciation are used – the straight-line Straight Line DepreciationStraight line depreciation is the most commonly used and easiest method for allocating depreciation of an asset. With the straight lineand declining balance methods.

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 can envision, deferred income tax arises when accountants use different depreciation methods other than the straight-line method and the declining balance method.

More Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. 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.
• 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
• Intangible AssetsIntangible AssetsAccording to the IFRS, intangible assets are identifiable, non-monetary assets without physical substance. Like all assets, intangible assets
• MACRS DepreciationMACRS DepreciationMACRS Depreciation is the tax depreciation system that is currently employed in the United States. The MACRS, which stands for Modified