Income Tax: Current Vs. Deferred

Income tax is type of direct tax levied by a government on businesses. Income tax due in a period is calculated by applying the applicable tax percentage to the taxable income of the business.

Taxable income is the net income calculated in accordance with the tax laws.

Taxable income = taxable revenues – tax-deductible expenses – tax exemptions

It is different than accounting income, which equals revenue recognized under GAAP minus expenses allowed under GAAP.

Accounting income = revenues under GAAP – expenses under GAAP

Accounting for income tax is complex due to the fact that there is a difference in financial accounting treatment of transactions and their tax accounting treatment. Let’s take different components of a business’s tax accounting one by one.

Current income tax obligation

Determining the current income tax payable is the most straightforward, because it represents a business’s tax obligation related to the current period taxable income.

Current income tax obligation = taxable income × tax rate

Matching concept of accounting suggests that tax expense for revenue should be recognized in the period in which the relevant revenue was recognized. Similarly, tax shield i.e. the reduction in tax expense due tax deductibility of an expense should be recognized in the period in which the relevant expense is recognized.

We determined that taxable income is different than accounting income. It means that the current income tax payable is not a good representation of current tax expense. It should be adjusted. For example:

These adjustments result in the concept of deferred taxation.

Deferred taxation

Deferred taxation is the process of transferring tax expense between different periods in order to better match revenues with expenses through a process called deferred taxation.

In order to better understand this process of deferred taxation and calculate current income tax, we need to define a few income statement and balance sheet accounts.

Deferred tax liability

Deferred tax liability is amount of tax a business shall be required to pay in future related to (a) revenues recognized in current period under GAAP but not under tax laws (i.e. not taxed in current period), which shall be taxed in future periods, and (b) expenses (not recognized under GAAP) that are allowed as tax deduction in current period but which shall not be allowed as deduction in future periods.

In other words deferred tax liability represents tax effects of transactions that will result in future increases in taxable income.

Deferred tax asset

Deferred tax asset is the amount of tax a business shall pay less in future due to the fact that (a) revenues that are taxed today shall not be taxed in future (when they will be eventually recognized under GAAP) and (b) expenses (that are recognized under GAAP in current period) that are not deducted in calculating taxable income in current period but which shall be deducted in future periods.

In other words deferred tax asset represents tax effects of transactions that will result in future decreases in taxable income.

Deferred tax expense

Deferred tax expense is the sum of any increase in deferred tax liability over a period minus an increase in deferred tax asset over the period. Deferred tax expense may be negative which results in current tax expense being less than current income tax obligation.

Current tax expense

Current tax expense equals a business’s current income tax obligation adjusted for the effect of transfer of income tax between different periods i.e. deferred taxation.

Current tax expense = current income tax obligation + deferred tax expense

Where deferred tax expense is negative for a period, current tax expense is lower than current income tax payable.

The expression above can be expanded as follows:

Current tax expense = current income tax obligation + closing deferred tax liability – opening deferred tax liability – (closing deferred tax asset – opening deferred tax asset)

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork