An investor reviewing the financial statements of a corporation might have a tough time figuring out how much that company paid in income taxes. That's because of differences between the accounting standards that underpin financial statements and the rules in place for preparing tax returns. Financial accounting produces the figure known as "income tax expense," while tax accounting produces "income tax payable." They're related, but typically not the same.
Major differences between tax accounting and financial accounting affect such things as how companies depreciate their capital assets, how they report inventory costs and how they account for anticipated warranty expenses. Because of such differences, the expenses reported on the company's income statement are different from those used as deductions on the company's tax return. Since expenses directly reduce profit, the income statement and the tax return will also show different profit figures. And corporations are taxed on their profits.
Income tax expense is the figure the company reports on its income statement. It is what the company would owe in taxes based on the pre-tax profit reported on the income statement. You can think of it as what the company thinks it "should pay." The company claims this as an expense -- even though it's not what the company actually pays. It may be more or less than the company's actual tax bill.
Income tax payable represents what the company actually owes in taxes -- what the government expects it to pay -- based on the pre-tax profit reported on its tax return. Income tax payable appears on the balance sheet as a current liability, a financial obligation to be met in the next year. It should be noted that over the long term, the differences between tax accounting and financial accounting are assumed to "even out." Eventually, a company will report the same total expenses under each system, so the total tax expense and the total tax payable will be the same. In any given year, however, there may be a big difference.
Deferred Tax Asset
When tax expense is different from tax payable, the difference must be accounted for on the balance sheet. Say a company has a tax expense of only $200, but its actual tax bill comes out to $250. The company, of course, must pay that larger amount, so it creates a balance sheet liability of $250 for income tax payable. On the asset side of the balance sheet, it creates a "deferred tax asset" of $50. What the company is doing is essentially acting as if it is paying $50 "extra" on its taxes, with the amount "overpaid" treated as an asset. Down the road, the company's tax expense will exceed its actual tax bill by $50 -- and at that point, the company will "use up" the $50 deferred asset to keep its books in balance.
Deferred Tax Liability
Sometimes the company's tax expense will exceed its actual tax bill. For example, a company may have a tax expense of $225 and a tax bill of $200. In that case, the company acts as if it will "underpay" its taxes. It creates a $200 liability for tax payable, but it creates a separate "deferred tax liability" of $25 to represent the "underpayment" that at some point will have to be made up. In the future, when tax expense falls $25 short of the actual tax bill, the company will use the deferred liability to make up the difference and balance its books.
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton, et al
- The Tax Foundation: Three Differences Between Tax and Book Accounting that Legislators Need to Know
- Millsaps College: Accounting for Income Taxes