Most large corporations prepare two sets of financial records – one set for investors and one set for tax authorities. Prepare the set of financial records intended for investors according to GAAP standards. Furthermore, it is meant to accurately portray the company’s financial performance and condition. Then prepare the set of financial records intended for tax authorities according to IRS tax laws. As a result, it is meant to minimize the taxes the company has to pay.
Sometimes, the two sets of financial records differ in terms of taxes. This can result in the company paying taxes not been incurred according to the GAAP records. This creates a deferred tax asset on the balance sheet in the GAAP records called prepaid income tax. Or it can result in the company incurring taxes according to the GAAP records that don’t yet have to be paid according to the IRS records. This creates a tax liability on the balance sheet in the GAAP records called deferred income tax. Differences in the timing of the recognition of expenses and revenues typically causes these discrepancies. Or the usage of differing methods of depreciating assets in the two sets of financial records causes these discrepancies.
When the company pays income taxes before recognizing the need to pay those income taxes, record the amount paid as an asset on the balance sheet. This is because it represents a future benefit to the company. Call the asset account prepaid taxes. When the company recognizes the need to pay income taxes before those income taxes are actually paid, record the amount as a liability on the balance sheet. Why? Because it represents a future obligation of the company. Call the liability account deferred income tax.
For example, if a corporation prepares two sets of financial statements and uses different accounting techniques in each set of documents, then the tax records may end up showing different amounts. Let’s say the ABC Company prepared one set of financial statements for the IRS. It shows a tax expense of $150,000.
During that same fiscal period, the set of financial statements the company prepared for investors shows the company owes taxes of $200,000. The difference of $50,000 has not yet been paid because according to the IRS financial statements, it is not owed yet. The $50,000 represents taxes owed according to the GAAP financial statements. In conclusion, this amount indicates an obligation to pay income taxes in the future.
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