Income taxes I: current and deferred tax

Northlake's accounting profit and its taxable income are almost never the same number. Accounting standards aim to measure performance; tax law aims to raise revenue and encourage certain behavior, such as investment in machinery. Tax law often lets a company deduct an asset's cost faster than the asset is depreciated in the financial statements, taxes some revenue when cash is received rather than when it is earned, and denies deductions for some expenses entirely. If a company simply reported the tax it owes for the year as its tax expense, that expense would bear little relation to the profit in the same income statement. Deferred tax accounting fixes this by recognizing the future tax consequences of transactions already recorded.

This lesson and the next apply ASC 740, Income Taxes, and, for comparison, IFRS's IAS 12. The details of US tax law, how MACRS and bonus depreciation work, how taxable income is computed, belong to tax courses. Here, tax law is a given; the question is how to account for it.

Accounting profit, taxable income and two kinds of differences

Accounting profit (or pre-tax book income) is profit before tax expense measured under the financial reporting framework. Taxable income is income on which tax is payable, measured under tax law. The differences between them are of two kinds. Permanent differences arise from items that are recognized in one measure but never in the other: fines and penalties, which are not deductible; half of business meal and entertainment costs, which both Canada and the United States disallow; and some income, such as most dividends received by a Canadian corporation from another Canadian corporation, which is not taxed. Permanent differences affect the effective tax rate but never create deferred taxes.

Temporary differences arise because an item is recognized in both measures but in different periods. A machine deducted for tax faster than it is depreciated in the books creates a temporary difference that reverses as book depreciation catches up. A warranty provision recognized as an expense when products are sold but deductible for tax only when claims are paid creates a temporary difference that reverses as claims are paid. ASC 740 defines temporary differences using the balance sheet: a temporary difference is the difference between the reported amount of an asset or liability and its tax basis.

The balance sheet liability method

Under the asset and liability method of ASC 740, the entity compares each asset and liability's reported amount with its tax basis. A taxable temporary difference gives rise to a deferred tax liability; an asset carried above its tax basis, because tax depreciation has run ahead of book depreciation, is the classic example. A deductible temporary difference gives rise to a deferred tax asset; a warranty liability with a tax basis of zero is the classic example. Deferred tax assets also arise from net operating loss and tax credit carryforwards (lesson 8).

Deferred tax is measured at the enacted tax rates expected to apply when the temporary difference reverses. Under US GAAP a rate change is recognized only when the law is enacted, signed by the President, not when it is substantively enacted as under IFRS. Deferred tax is not discounted. The examples use a combined rate of 25 percent, illustrative of the 21 percent federal rate set by the Tax Cuts and Jobs Act of 2017 plus a typical state rate net of the federal benefit; actual state rates vary widely.

A worked example over four years

At the start of 2027 Northlake buys $1,200,000 of production machinery. In the books, it is depreciated straight-line over four years with no residual value, $300,000 a year. For tax, Northlake claims 100 percent bonus depreciation in 2027, which the One Big Beautiful Bill Act of 2025 made permanent for qualifying property acquired after 19 January 2025 (check current rules). Pre-tax accounting profit is $6,000,000 in each year. Non-deductible meals of $40,000 a year (half of $80,000 spent) are a permanent difference.

# Deferred tax on machinery with 100% bonus depreciation (25% combined rate, illustrative)
rate = 0.25
cost, life = 1_200_000, 4
book_dep = cost / life
tax_ded = [cost, 0, 0, 0]
pretax, nondeductible = 6_000_000, 40_000
carrying, tax_base, dtl_prev = cost, cost, 0
print(f"{'Year':>4} {'Taxable inc':>12} {'Current tax':>12} {'Temp diff':>10} {'DTL':>9} {'Deferred exp':>12} {'Total exp':>10} {'ETR':>7}")
for y in range(4):
    taxable = pretax + nondeductible + book_dep - tax_ded[y]
    current = taxable * rate
    carrying -= book_dep; tax_base -= tax_ded[y]
    temp = carrying - tax_base
    dtl = temp * rate
    deferred = dtl - dtl_prev; dtl_prev = dtl
    total = current + deferred
    print(f"{2027 + y:>4} {taxable:>12,.0f} {current:>12,.0f} {temp:>10,.0f} {dtl:>9,.0f} {deferred:>12,.0f} {total:>10,.0f} {total / pretax:>7.2%}")

Year  Taxable inc  Current tax  Temp diff       DTL Deferred exp  Total exp     ETR
2027    5,140,000    1,285,000    900,000   225,000      225,000  1,510,000  25.17%
2028    6,340,000    1,585,000    600,000   150,000      -75,000  1,510,000  25.17%
2029    6,340,000    1,585,000    300,000    75,000      -75,000  1,510,000  25.17%
2030    6,340,000    1,585,000          0         0      -75,000  1,510,000  25.17%

In 2027 taxable income is only $5,140,000 because the full $1,200,000 is deducted against $300,000 of book depreciation, so current tax is $1,285,000. But the machine's carrying amount, $900,000, now exceeds its tax basis of zero by $900,000: Northlake will have $900,000 more taxable income than book income over the next three years. A deferred tax liability of 900,000 × 25% = $225,000 is recognized, and deferred tax expense of $225,000 brings total tax expense to $1,510,000. In each later year the liability falls by $75,000 as the difference reverses, giving a deferred tax benefit that offsets higher current tax. Total tax expense is $1,510,000 every year, and the effective rate is a steady 25.17 percent, slightly above 25 percent because of the non-deductible meals.

The example shows why deferred taxes exist. Without them, Northlake would report a low tax expense in 2027 and higher expense in 2028 to 2030, even though its pre-tax profit was the same every year. Accelerated tax deductions defer tax; they do not eliminate it, as long as the company is profitable. For a growing company that keeps buying equipment, however, new deductions keep replacing reversing ones, and the deferred tax liability can grow for many years, a fact some analysts use to argue that it behaves more like equity than debt.

Deductible temporary differences: the warranty provision

Changes in tax rates and other recognition issues

When tax rates change, existing deferred tax balances are remeasured at the new rate in the period the change is enacted, and the effect is recognized in income from continuing operations, even if the original item was recorded in other comprehensive income (a 2018 accounting update allowed a one-time reclassification of these 'stranded' effects after the 2017 rate cut). If a state raised its rate so that Northlake's combined rate rose by one percentage point while it had a $600,000 temporary difference, the deferred tax liability would rise by $6,000, increasing tax expense in the year of enactment.

ASC 740 does not have IAS 12's initial recognition exception. Deferred taxes are recognized on almost all temporary differences, with some exceptions, such as goodwill that is not deductible for tax and certain undistributed earnings of foreign subsidiaries that are indefinitely reinvested. For leases, deferred taxes are recognized on both the right-of-use asset and the lease liability.

Presentation

Since ASU 2015-17, all deferred tax assets and liabilities, along with any valuation allowance, are classified as non-current on the balance sheet. Within a tax-paying component and jurisdiction, deferred tax assets and liabilities are offset and presented as a single amount. Income tax expense is presented in the income statement, with tax effects of other comprehensive income items presented in OCI.

Deferred tax on leases, revaluations and investments

Three further situations show how widely the asset and liability method reaches. First, leases: when Northlake recognizes its warehouse lease (lesson 5), the right-of-use asset of $842,473 has a tax basis of zero, because US tax law deducts rent as it is paid, and the lease liability has a tax basis of zero as well. Northlake recognizes a deferred tax liability on the asset and a deferred tax asset on the liability, which for an operating lease move almost in step because the asset is measured as a plug that tracks the liability. Second, items recognized in other comprehensive income, such as unrealized gains on available-for-sale debt securities, carry their deferred tax in OCI: the tax is allocated to the same place as the item, a process called intraperiod tax allocation, which also allocates tax among continuing operations, discontinued operations and equity.

Third, investments in subsidiaries: the parent's book basis in a foreign subsidiary can exceed its tax basis because of undistributed earnings. ASC 740 does not require a deferred tax liability on the outside basis difference of a foreign subsidiary if the earnings are indefinitely reinvested, an assertion management must support; the 2017 tax law's one-time transition tax and move toward a territorial system reduced the significance of this exception, but withholding taxes and state taxes can still apply. These topics return in ACCT-311, which covers consolidation and foreign operations.