Companies keep two sets of financial records. One is for reporting their performance to investors, following rules called Generally Accepted Accounting Principles (GAAP). The other is for the IRS, following the tax code. These two sets of rules don't always agree on when to record income or expenses.

This mismatch creates what are known as deferred taxes. A deferred tax is a tax that is either owed for the current period but not yet paid, or paid in the current period but not yet recognized on the income statement. It’s an accounting tool to bridge the gap between what a company reports to the public and what it reports to the tax authorities.

The profit a company shows investors is its accounting profit, or “book income.” The profit it reports to the IRS is its taxable income. They are often different because their goals are different. Financial accounting aims to give a smooth, accurate picture of a company’s financial health over time. Tax law, on the other hand, is designed to raise revenue for the government and can include incentives to encourage certain business behaviors.

For example, a company might use one depreciation method for its financial statements and a different, accelerated method for its tax return to lower its immediate tax bill. This is perfectly legal and very common.

These are called temporary differences because eventually, the total amounts will match up. The depreciation will total the asset's cost, and all the revenue will be counted. It's just a question of when.

These timing differences create either a deferred tax liability or a deferred tax asset on a company's balance sheet.

Think back to the depreciation example. If a company uses accelerated depreciation for tax purposes, its taxable income is lower in the early years of an asset's life. This reduces its current tax bill. However, the company knows that in later years, the tax deductions will be smaller, and its tax bill will be higher. The deferred tax liability represents this future tax payment.

Imagine a company that sells products with a three-year warranty. For financial reporting, it estimates and expenses the future warranty costs in the year of the sale. But for tax purposes, it can only deduct those costs when it actually pays a customer's claim. In the year of the sale, the company pays tax on a higher income than its books show. This prepayment of tax creates a deferred tax asset, which will be used to reduce taxes in future years when warranty claims are paid.

Accountants aren't just making this up. The rules for deferred taxes are laid out in specific accounting standards. In the United States, companies following U.S. GAAP use a standard known as ASC 740. For companies using International Financial Reporting Standards (IFRS), the relevant standard is IAS 12.

These standards ensure that companies account for taxes consistently and provide a clearer picture of a company's future tax obligations and benefits. They help investors understand the true financial position of a business, beyond just the tax paid in a single year.

Now, let's check your understanding of these core concepts.

Understanding deferred taxes is crucial for deciphering a company's true financial health. It reveals the important differences between how a company presents itself to the public and how it accounts for its obligations to the government.