Deferred income taxes represent the future tax consequences of temporary, or timing, differences between how a company reports its revenues and expenses on its financial statements and how it reports the same items on its income tax return. These differences are temporary because they eventually reverse — the total amount of income or expense recognized over an asset's or transaction's entire life ends up the same under both sets of rules, but the timing of when each dollar is recognized differs from one period to the next.
How timing differences create deferred taxes
The most common example is depreciation: a company frequently uses straight-line depreciation for its financial statements but accelerated depreciation for its income tax return, since accelerated methods reduce taxable income, and therefore taxes actually owed, in the earlier years of an asset's life. Because book depreciation and tax depreciation differ in timing even though they total to the same amount eventually, the company's reported income tax expense on its financial statements, which is based on book income, differs from the actual cash taxes it currently owes the government, which is based on taxable income, and that difference is recorded as a deferred tax asset or deferred tax liability.
Deferred tax liabilities versus deferred tax assets
A deferred tax liability arises when a company has paid less tax currently than its book income tax expense suggests, implying it will owe more tax in a future period once the timing difference reverses — the common result of using accelerated depreciation for tax purposes while using straight-line for financial reporting. A deferred tax asset arises in the opposite situation, where a company has effectively prepaid tax relative to its book income, implying it will pay less tax in a future period, often arising from expenses recognized on the financial statements before they become tax-deductible, such as an estimated warranty liability or an allowance for doubtful accounts.
Why deferred taxes matter to readers of financial statements
A company's reported income tax expense on its income statement is not simply the cash it actually paid the tax authorities during the period; it includes both the current tax actually owed and the deferred tax effect of timing differences that will reverse in future periods, which is why total income tax expense and actual cash taxes paid can diverge meaningfully in any given year. Analysts examining a company's tax position look at both the current and deferred components of income tax expense separately, since a company relying heavily on deferred tax benefits to support reported earnings is, in effect, borrowing against future tax obligations that will eventually need to be settled.
Deferred taxes and changes in tax law
Deferred tax balances must be remeasured whenever tax rates or rules change, since they represent future tax effects calculated using whatever tax rate is expected to apply when the timing difference actually reverses; a significant change in corporate tax rates, for example, can require companies to record a one-time adjustment to their existing deferred tax asset and liability balances, even though no new timing difference has actually occurred, simply because the rate used to measure the existing balances has changed.