What is deferred tax?
Deferred tax is defined as an accounting measurement of future tax consequences for a given enterprise. It is the tax that has not yet been levied by the government, but still needs to be calculated and subsequently disclosed in the financial statements in accordance with the accrual concept. As per the accrual concept, the tax impact of a given transaction should be disclosed, and subsequently recorded in the same accounting period in which the expense has been incurred.
Deferred Tax Liability, and Deferred Tax Asset
Deferred tax liability and a deferred tax asset are created as a result of temporary differences between the taxes recorded in the books, and the actual tax incurred. During the normal course of business, there are several different types of transactions that are incurred, which result in differences between the tax recorded, and the actual tax incurred. This results in the creation of tax assets, and liabilities.
From an investors’ perspective, it can be seen that the information pertaining to deferred taxes can be obtained within the footnotes presented in the financial statements. Mostly, companies outline major transactions that have been incurred during the period that result in a fluctuation of the tax amount, eventually impacting the creation of tax liability or tax assets. The effective tax rate is also mentioned within the tax footnotes in the financial statements, which help establish a greater degree of understanding regarding the applicable tax rate, and the subsequent tax payment that was made as a result of this.
Additionally, it must also be noted that having a proper understanding of the deferred tax assets, and liabilities, as well as the net amount of two, helps companies (as well as investors) to understand the cash flow movements of the company.
Deferred Tax Liability: Deferred tax liability is created in the case where the carrying value of an asset is greater than the tax base. On the contrary, if a given liability has a carrying value lesser than the tax base, in that case too, a temporary difference arises that results in a deferred tax liability.
Deferred Tax Asset: Deferred tax asset is created when the carrying value of an asset is less than the tax base. This is because the difference between the carrying value and the tax base creates a deductible temporary difference that can be claimed by the company. On the other hand, if the carrying value of a given liability is higher than the tax base, in that case too, the temporary difference that is created results in a deferred tax asset.
Impact of Deferred Taxes on Cash Flow Statement
From a company’s perspective, it is highly important to understand the impact of deferred tax balance, and the impact it has on the future operations of the company. Factually, deferred tax assets and liabilities do have a very profound impact on the cash flow position of the company. An increment in deferred tax liability or a decline in deferred tax assets is considered a source of cash. In the same manner, a decrease in deferred liability, or an increase in the deferred asset is considered to be a use of cash.
In the same manner, analyzing the change in deferred tax balances is also important because it helps to understand the future trend of these balances in the near future. For example, these trends are also critical in showcasing the type of business a company has undertaken. An increase in deferred tax liability implies that the company is capital-intensive. This is primarily because of the fact that the purchase of new capital assets is coupled with accelerated tax depreciation, which is higher in propensity in comparison to the depreciation of older assets.
This implies that in the case where tax depreciation is greater than the depreciation expense in years 1 and 2, the entity has received tax relief at an earlier date. This is good for the cash flow of the company because it delays (and defers) the payment of tax. The difference, however, is the fact that the difference is temporary, and needs to be paid for in the future years. In the latter years, when the tax depreciation is less than the charged depreciation, the entity is then charged with additional tax, and the temporary difference is then reversed.
Therefore, to summarize the impact of deferred tax on cash flow statement, the following points can be noted:
- An increase in deferred tax asset results in cash outflow, hence it is adjusted on the negative side (deduction in cash).
- A decrease in deferred tax asset results in cash inflow, hence it is adjusted on the positive side (addition of cash).
- An increase in deferred tax liabilities result in cash inflow, and hence, it is adjusted on the positive side (addition of cash).
- A decrease in deferred tax liabilities results in cash outflow, hence it is adjusted on the negative side (deduction of cash).
Presentation of Deferred Taxes in the Cash Flow Statement
Deferred tax is a liability (or an asset) presented in the cash flow statement. Since this is a non-cash expense, it is not presented in the cash flow under the direct method. However, under the indirect method, deferred taxes are represented in the operating cash flow section as an adjustment to the profit (or loss) before tax.
In case of any increase in the deferred tax assets, or a decrease in deferred tax liabilities, the amount is subtracted from the net income (or net loss). Alternatively, in case of any decrease in deferred tax asset, or an increase in deferred tax liability, the amount is added back to the net profit (or net loss).
The following illustration shows the impact of deferred taxes on the cash flow statement:
| Particular | 2019 | 2020 |
| Cash Flow from Operating Activities | ||
| Net Income | 10,000 | 12,000 |
| Provision (or benefit) from Deferred Taxes | 2,000 | (3,000) |
Example of Deferred Tax and Impact on Cash Flow
James Inc. had a trade receivable balance equivalent to $10,000 and $15,000 at the end of 2017 and 2018 respectively. The tax base used for computing tax was equivalent to $12,000 in 2017, and $10,000 in 2018. The applicable effective tax rate was 30%.
In the same of 2017, the deductible difference between the carrying amount of the asset (i.e. $10,000) and the tax base (i.e. $12,000) is $2000. This results in a deferred tax equivalent to $600 ($2,000 x 30%).
In 2018, there was a deductible difference of ($5,000), since the carrying amount of the asset (i.e. $15,000) is higher than the tax base applied (i.e. $10,000). This resulted in a deferred tax liability worth $1,500 ($5,000 x 30%).
Therefore, the company has one deferred tax asset worth $600, and one deferred tax liability worth $1,500. Netting the two, the company now has a deferred tax liability worth $900.