All companies calculate their income taxes using two sets of rules:
The Income Tax Expense line on the Income Statement represents the amount of tax that a company reports for accounting purposes. It is calculated based on accounting rules that dictate how a company needs to recognize revenues and expenses. These accounting rules can be quite different from the rules used to calculate how much tax a company has to pay to the government in cash during a given period. This latter set of rules is determined by the governments of various countries where a company has operations and pays tax.
Under these two different sets of rules, differences will often occur because revenues and expenses are recognized at different times. These differences are commonly called “timing differences.”
There are many items that can cause timing differences between accounting tax and government tax.
For many companies, depreciation expense can cause a big difference between taxable income for accounting purposes and for government purposes. Under accounting rules, many fixed assets are depreciated on a straight-line basis over their estimated useful lives. However, for government purposes (in many countries), fixed assets are depreciated on an accelerated basis. This means that the company can deduct more of the asset’s cost earlier in the asset’s life for tax purposes. Governments around the world allow this type of pattern of deduction to incentivize investment. The incentive happens because as companies buy fixed assets, they record a large depreciation expense on their government tax return in the early years of the investment which reduces their government taxable income and therefore the amount of cash tax paid.
Note that the full cost of the asset will eventually get expensed through depreciation on both the accounting and government books - the difference relates to the timing of the expenses over time. These timing differences are therefore called “temporary”.
Below is a simple example of the differences in the accounting value versus government tax value for a fixed asset after 1 period where the government tax depreciation exceeds the accounting depreciation:
Many other accounts, such as inventories, accrued expenses and pensions can also cause timing differences. Any income or expense that is treated differently for accounting purposes vs. government purposes will cause a timing difference, and therefore result in taxable income that is different for accounting vs. government purposes.
Income Tax Expense as it appears on the income statement is always made up of:
You can find the breakdown of the components in the Income Taxes footnote to the financial statements – normally companies provide a lot more detail in their annual disclosure than in their quarterly disclosure.
In the sample tax footnote below, taxes are broken down between current and deferred, and the current is further segmented by region. The line called “Total provision” is what appears on the income statement.
Current Tax Expense is the tax payable to the government recognized during a given financial reporting period. This amount is calculated based on income and deductions permitted by governments. It is a close proxy to the amount of cash tax paid during a period.
However, it is important to note that this amount of Current Tax will likely differ from the actual cash tax paid. This is because companies will make actual cash payments to governments based on required timing of installments. To the extent a company recognizes more Current Tax than it has paid in cash, this would create a liability called Income Tax Payable.
Deferred Tax Expense is the difference between Current Tax Expense and the total Income Tax Expense that appears on the income statement. Here are some general rules:
If Government Taxable Income < Accounting Taxable Income, the company will owe less cash tax than what is reported as the total tax expense on the income statement, and will record a Deferred Tax
Expense on their Income Statement This is a non-cash expense and must be added back to Net Income on the cash flow statement
If Government Taxable Income > Accounting Taxable Income, the company will owe more cash tax than what is reported as the total tax expense on the income statement, and will record a negative Deferred Tax Expense (i.e. a Deferred Tax Benefit) on their Income Statement
This is a non-cash benefit and must be deducted from Net Income on the cash flow statement
The following is a simple example where depreciation expense causes the timing difference:
The difference between accounting tax and government tax is called “deferred” because the timing differences that cause this are temporary and the deferred tax should get paid eventually. In other words, the timing differences will reverse themselves at some point and the deferred tax will eventually get paid with cash.
Using the example of depreciation from above, toward the end of the asset’s useful life, the company will still expense the same straight-line amount, but the deduction for government purposes will be comparatively small or even nil because the government depreciation was higher in earlier periods. The result, all else being equal, is that in this future period the Current Tax will exceed Total Income Tax (i.e. Accounting Tax), which in turns means the company will record a negative Deferred Tax Expense (i.e. a Deferred Tax Benefit) on the Income Statement.
In the example below, by period 10 we are assuming all of the government depreciation has been deducted in earlier periods:
Deferred Tax Assets (“DTA’s”) and Deferred Tax Liabilities (“DTL’s”) are essentially what make the balance sheet balance when Current Tax is different from Total Tax Expense. Take for example a situation where Deferred Tax on the income statement was an expense, because of excess government depreciation over accounting depreciation in period 1:
Since Deferred Tax is a non-cash expense, it would get added back to operating cash flow on the cash flow statement. This means that Net Income, and therefore the increase in Retained Earnings on the balance sheet, is lower than the change in cash on the balance sheet.
In the table below, note that period 1 operating cash is increasing by $22.5 mm (the $1.5 mm Deferred Tax Expense was a non-cash reduction in net income so it needed to be added back). However, Retained Earnings only went up by the amount of Net Income (assuming no dividends), or $21.5 mm. To balance the balance sheet, a Deferred Tax Liability of $1.5 mm is created:
Another way to think of this is that the Total Tax Expense made the company’s Equity (Retained Earnings) go down by $9.0 mm, but the company’s Assets (cash) only went down by $7.5 mm. A deferred tax liability of $1.5 mm therefore needed to be created to balance the balance sheet.
The Deferred Tax Expense creates a liability because at some point toward the end of the depreciable asset’s life, the timing difference will reverse itself. At that point, (all else being equal) the government tax deductions for depreciation will be very small (or nil) and the accounting expense will be the same straight-line amount – so in that period the company will recognize more cash tax than accounting tax. This will create a negative Deferred Tax expense (i.e. a Deferred Tax Benefit) on the Income Statement which will reduce the Deferred Tax Liability that was created in an earlier period:
In general, any item that results in lower government taxable income today vs. accounting income will create a Deferred Tax Expense on the Income Statement and therefore a Deferred Tax Liability (“DTL”) on the Balance Sheet.
Conversely, if an item causes government taxable income to be higher today than the corresponding accounting taxable income, the company will record a negative Deferred Tax Expenses (i.e. a Deferred Tax Benefit) on the income statement and a Deferred Tax Asset (“DTA”) on the balance sheet.
The figure below shows a typical footnote presentation of a company’s DTA and DTL position at the end of the fiscal year. Notice that “Accelerated depreciation” on fixed assets creates DTLs as per the example above. On the other hand, the recognition of accounting accruals (such as estimated expenses for bad debt) creates a DTA when a deduction is not yet permitted for government purposes:
When a company has negative pre-tax income for government purposes, a tax loss is created. In the U.S., this is called a Net Operating Loss (“NOL”) while in Canada it is a Tax Loss Carryforward (“TLCF”). This tax loss can be carried forward (the amount of time into the future depends on the country) to shelter tax on any positive taxable income in the future. It can also be carried back for a certain period of time in some countries.
When a company records a tax loss, a Deferred Tax Benefit is typically created on the income statement along with a corresponding Deferred Tax Asset on the balance sheet. In the example below, the company had $361.3 mm of DTAs related to “net operating losses” at year end 2016. However, this is not the amount of the losses (NOL), but rather the tax savings to be generated in the future if the NOLs are used. The gross amount of the NOLs is typically disclosed in a paragraph in the income tax footnote (usually in the annual financial disclosure).
This company had over $1.5 billion of NOLs at the end of 2016. If a company does not disclose the total amount of its NOLs / TLCFs, this number can be approximated by taking the amount of the Deferred Tax Asset related to the NOLs / TLCFs as disclosed in the tax note and dividing it by the company’s tax rate.
If there is more than a 50% probability that a Deferred Tax Asset (“DTA”) or some portion of it may not get used, the company creates a valuation allowance that is netted against the carrying value of the DTA (see example in the table below). Any changes in the valuation allowance are recorded on the income statement. Typically, valuation allowances are created when a company has Net Operating Losses (“NOLs”) and (a) has a history of NOLs expiring unused or (b) is expected to generate further losses in the next several years.
A company’s Effective Tax Rate is simply the total Income Tax Expense on the income statement divided by the Earnings Before Tax on the income statement. This rate often differs from the “Statutory Tax Rate” (often the rate for the company’s home jurisdiction) for a number of reasons. As seen in the example below, tax rate differentials on income taxed in foreign countries can cause a big difference between the effective rate and the statutory rate. However, one-time items can also cause large swings:
