This term is more of an accounting term than a taxation term. The GAAP (Generally Accepted Accounting Principles) and Accounting Standard's definition regarding income is a bit different from the one that has been prescribed by the Internal Revenue Service (IRS).
The difference in the two definitions is due to the fact that as per income tax regulations, actually received money becomes income, and from the accounting and bookkeeping point of view, income accrued and receivable is either recognized as an asset, or income, or both, in certain cases. The deferred tax refers to the income tax that would be levied on such unreceived incomes at a future date.
About Deferred Income Tax
From the accounting point of view the anticipated income is taken to asset side of the balance sheet, whereas the income is recorded in the profit and loss account. The same logic is also applicable for expenditures.
The anticipated and recognized expenditures tend to have certain tax implication, that is they can be subject to deductions. The concept of deferred tax is basically used to find financial solutions to problems, make financial provisions and plan tax. In order to understand the deferred tax expense in a better manner, the explanation has been divided into two parts, the liability side and the asset side.
From the financial perspective, we need to understand that there are three implications of every transaction, that is, it either results into a profit or loss, which affects the tax liability. This may either increase or decrease, based upon increase in income or deduction. The final effect is always on any one side of the balance sheet. Here is what actually takes place...
Assets and Profits
The basic rule goes that more income, more tax liability, and more value of the asset side. For example, let us assume that a business firm made a large investment which had accruing returns, receivable after 5 years. Hence in the first year, let's say, an interest of $1000 gets accrued on the investment. In such a situation, the balance sheet of the firm is going to show $1000 accrued interest on the asset side.
Similarly, the next four years, would show, $4000 with $1000 at every year, as the accrued interest on the asset side. At the end of 5 years, the balance would become $5000, and on the date of payment it would disappear, and appear as an income on the profit side of the profit and loss account. Now, the tax on $1000 is deferred income tax.
The wise procedure, that is followed by some firms, is that the $1000 for every year is included in the tax calculation, and the proportionate of that sum is set aside in another fund. This policy is basically, followed in order to distribute the total tax burden over several years. Also the payments by debtors, realization of some investments is planned in a similar manner.
In some cases, when tangible assets such as machinery or real estate is sold, the income amounts to a substantially large sum. In such instances, the taxation agencies permit the firms to distribute the income over certain years. This is to prevent firms from falling prey to high levels of taxation.
Liability and Loss
Losses in any business are inevitable. In case of losses, government bodies such as the IRS, permit the firms to deduct the losses over a certain time period. This works to the benefit of both, the tax collector and also the tax payer. Suppose a person, who was a debtor of the company, files for bankruptcy then the amount that is receivable is of course lost.
However, the deduction cannot be claimed unless and until the due date of the payment does not arrive. This date may also extend till the subsequent financial years. Forgiveness of liabilities is accounted as income. For example, if a creditor of the company forgives 50% of the interest payable, then the amount is considered as an income and would be taxed. In such scenarios the income is derived as per the installment schedule.
The deferred tax implications change as the side and element of the balance sheet that income affects.