Deferred tax assets and liabilities are the direct results of deferred taxes, which are based on temporary differences in recorded revenues or expenses between accounting books and tax returns. In other words, any difference in the tax basis of accounting income and taxable income causes a tax difference between the income tax expense reported for accounting books and income tax payable reported for tax returns. Deferred taxes can be deferrals for either the tax expense or tax payable, which generates deferred tax assets or liabilities respectively on a balance sheet.
Accounting Books
To record revenues and expenses in accounting books, companies must follow the generally accepted accounting principles, or GAAP, which is accrual-based. Under GAAP, companies record revenues when they are realizable and earned even though no cash has been received. Similarly, companies record expenses as they occur even though no cash has been paid. As a result, companies calculate their tax basis and report tax expenses in accounting books based on accounting income derived from revenues and expenses recorded using GAAP.
Tax Returns
Accounting income under GAAP may not reconcile at times with taxable income, the tax basis for calculating income tax payable required by the tax codes. Under the cash-based tax codes, companies record revenues and expenses only when they have received or paid cash, regardless of whether revenues have been earned or expenses have been incurred. As a result, if the amount of accounting income based on GAAP is different from that of taxable income based on the tax codes, the calculated income tax expense for accounting books would be different from income tax payable for tax returns, creating a tax deferral.
Deferred Tax Assets
When income tax expense is smaller than income tax payable as a result of deducting any noncash expenses in accounting books, some income tax expense is deferred to the future. The larger income tax payable on tax returns creates a deferred tax asset, which companies can use to pay for deferred income tax expense in the future. Deferred tax assets may be presented as current assets if a temporary difference between accounting income and taxable income is reconciled the following year.
Deferred Tax Liabilities
When income tax expense is greater than income tax payable as a result of no recognition of any noncash revenues in tax returns, some income payable is deferred to the future. The smaller income tax payable on tax returns creates a deferred tax liability, which companies must meet by paying any deferred income tax payable in the future. Deferred liabilities may be presented as current liabilities if a temporary difference between accounting income and taxable income is reconciled the following year.