Deferred Taxes are taxes that may appear on a company’s balance sheet as either an asset or a liability.
They arise due to timing differences in the taxable income of a corporation vs. its accounting income under Generally Accepted Accounting Principles (GAAP).
GAAP requires the recognition of deferred taxes to provide a proper matching to total tax expense with the accounting income for the year. A major reason for deferred taxes to arise is the difference between depreciation for accounting purposes and tax depreciation.
This is best seen by a simple example. Suppose a company has $1,000 income under GAAP, after providing for $100 in depreciation. However, the tax depreciation for the company is $180. We should also assume a 35% tax rate.
The company, then, will pay taxes of ($1,000+100-180) = 920 x 35% = 322.
We have added back the $100 in accounting depreciation and subtracted the $180 in tax depreciation to arrive at $920 in taxable income.
However, over time, the accounting depreciation will eventually catch up and overtake the tax depreciation. To provide for this, we must account for the tax on this timing difference of $80. The company will record a tax liability of 80 x 35% or $28.00
The total tax provided in the income statement of the company, then, will be $322 + 28, or $350 which is the total tax rate, 35% applied to the accounting income of the company.