Companies pay taxes that are determined by specific country laws and regulations. However, taxable profits are rarely the same as financial accounting profits which gives rise to deferred taxes in financial statements. This article describes the basic rules of determining deferred tax assets and liabilities and their presentation in the cash flow statement.
1. The deferred tax concept
Deferred tax is an accounting measurement of future tax consequences for an enterprise. It is not tax levied by the government, but the amount calculated by application of the accrual concept. According to the latter, the tax effects of any transaction should be recorded in the same accounting period as the transaction itself.
US GAAP and tax rules differ regarding recognition and measurement of assets and liabilities. This results in permanent and temporary differences.
Permanent differences (foreign currency movements, fines, political donations, etc.) are never allowed for tax purposes. Therefore, no deferred tax on such differences is calculated.
Deferred tax assets or liabilities are only caused by temporary differences, the most common examples of which are listed below:
- Depreciation is not deductable for tax purposes, but the cost of the related asset will be allowable upon sale or liquidation of the asset;
- A fixed asset is recorded at its fair value in consolidated financial statements, while it is carried at cost in financial statements of a single entity of the group;
- Unrealized profit in inventory is eliminated for consolidation, yet it is taxed at the individual entity level;
- Write down of slow-moving inventory in accounting is done while it is not allowed for tax deduction;
- Development costs are capitalized and amortized in accounting, but deducted in full when incurred in tax computations;
- Share-based compensation expenses are recognized in the income statement, while tax deductions are permitted only when share appreciation rights are exercised.
2. Basic deferred tax computation rules
If an asset carrying value is more than its tax base then a taxable temporary difference arises resulting in a deferred tax liability.
If an asset carrying value is less than its tax base then a deductible temporary difference arises resulting in a deferred tax asset.
And on the contrary, if a liability carrying value is more than its tax base then a deductible temporary difference arises resulting in a deferred tax asset.
If a liability carrying value is less than its tax base then a taxable temporary difference arises resulting in a deferred tax liability.
For example, at the balance sheet date a company has an interest receivable of $5,000; this amount will only be taxed in the next accounting period upon receipt. The tax rate is 30%. In this case, the carrying value of the asset amounts to $5,000, while its tax base is zero. In the current year, a taxable temporary difference arises resulting in a deferred tax liability of $1,500 (i.e., $5,000 x 30%).
3. Presentation of deferred taxes in the cash flow statement
Deferred tax is a non-cash item; therefore, it is not presented in the cash flow under the direct method. Under the indirect method, deferred taxes are shown in the operating cash flow section as an adjustment to the profit (loss) before tax.
Any increase in a deferred tax asset or decrease in a deferred tax liability is subtracted as part of adjustments to net income (loss). Vice versa, any decrease in a deferred tax asset or increase in a deferred tax liability is added back to net profit (loss).
For instance, the published 2013 Annual Report of General Motors shows:
Consolidated Statements of Cash Flows
(in millions)
|
2013
|
2012
|
Cash flows from operating activities
| ||
Net income
|
5,331
|
6,136
|
…
| ||
Provision (benefit) for deferred taxes
|
1,561
|
(35,561)
|
Namely, in 2012 the company reversed its deferred tax asset for a material amount due to increased profitability, while in 2013 the decrease in deferred tax asset is added back in the cash flow computation. (source)
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