Simple Deferred Tax Asset & Liability Explanation

If you have ever taken a look at the balance sheet of almost any publicly traded firm, you will probably notice either a deferred tax asset or a deferred tax liability. While these are relatively simple to understand, I wanted to take a few moments to talk about how these are created and how they will impact not only the GAAP financials, but also the valuation process.

To begin with, what is a deferred tax account? In the U.S. all public companies are required to follow U.S. Generally Accepted Accounting Principles (GAAP) for financial reporting. However, for tax purposes, they follow a slightly different system of accounting. The difference in treatment for certain items can leave a firm actually having different amount of taxable income for accounting books purposes than for tax. Some of these differences are permeate other are simply temporary. Let’s discuss the differences and see some examples.

Permanent Differences

Certain expense are never taxable or are never tax deductible under U.S. Tax law. Take for example the investment in a municipal bond; the coupon stream for muni bonds is never taxable at the Federal level. If a firm is invested in a muni bond, they will show a higher book income versus a taxable income. Now let’s look at a federal fine for pollution. While the firm will use this as an expense for accounting purposes (hopefully extraordinary) they are not allowed to write it off on their tax income and therefore will have a higher tax income than book income. Since issues like these are never reversed, the income tax expense associated with these is factored in on the tax expense for the respective period.

Temporary Differences

While permanent differences are relatively simply and straight forward, temporary differences can be much trickier. Take for example the differences in depreciation methods. Most firms will choose to depreciate an asset under the straight line method, however under U.S. Tax law a system of depreciation called MACRS is used. This is essentially and accelerated deprecation system. This will generally cause the firm to have higher book taxable income in the early years and lower book taxable income in the later years versus the tax accounting income.

If a firm has a book taxable income of $1,000 but a tax accounting taxable income of $800 with a 40% tax rate what will they expense and what will they pay? For accounting purposes they will have income tax expense of $400; however, they will actually only have a tax liability of $320. Now since the difference is temporary and will reverse at a later time, they must account for this. To do this they will create an account-either an asset or a liability. From a valuation stand point, we must remember that the cash flows will be effected due to the differences between actual tax expense and tax liabilities paid in cash.

Since I think some of this can be a bit hard to explain in writing, I have decided to create a short screen cast. I hope this helps make this issue a bit clear.

I do understand that this is not an extensive explanation of deferred tax assets or liability, but I do hope it lays the foundation for a better understanding. 

Excel Model: Defered Taxes & Valuation Example