A company's accounting profit may differ significantly from its taxable income because of timing issues or differences in accounting methods. A deferred tax asset or liability account is used to track these differences on the general ledger. Some of these differences will reverse in the next tax year so there is no permanent discrepancy between the company's books and its tax return. Other differences are permanent and must be carried on the general ledger each year.
Timing differences between a company's tax accounting and its general ledger will automatically resolve themselves in a future year. Differences in depreciation or amortization methods often cause these temporary discrepancies. Recognizing income on the books before it is actually received will also create a temporary difference in taxable income.
Certain items are included as accounting profit but are not taxable. Unlike temporary differences caused by timing issues, these differences are permanent and do not resolve in the next tax year. Life insurance proceeds and non-taxable interest earned on municipal bonds are two examples of permanent differences in income. The company does not record a deferred tax item on its general ledger when these permanent differences occur.
Deferred Tax Accounts
If the company records a tax deduction on the general ledger that may not be taken in the current tax year, a deferred tax asset is shown on the balance sheet. The other side of the journal entry is a credit to income tax revenue. Income items that are recorded in the current year and taxed in a future year create a deferred tax liability on the books and an offsetting income tax expense. Income tax expense and revenue accounts should be listed in the "Other Income" section of the income statement.
You must determine the effective tax rate before you can make the journal entries for timing differences between accounting profit and taxable income. If your company's income is taxed at 30 percent and it takes a deduction of $10,000 in the current year that is not reported until the next year's tax return, you would enter a $3,000 credit to the income tax revenue account and a $3,000 debit to the deferred tax asset account. To record $100,000 of revenue recognized in one year and not taxed until the next, you would enter $30,000 as a debit to the income tax expense account and a credit to the deferred tax liability account.
- Comstock/Comstock/Getty Images