How deferred taxes are presented in the cash flow statement

December 3, 2014

Companies pay taxes that are determined by specific country laws and regulations. However, taxable profits are rarely the same as financial accounting profits which gives rise to deferred taxes in financial statements. This article describes the basic rules of determining deferred tax assets and liabilities and their presentation in the cash flow statement.

1. The deferred tax concept

Deferred tax is an accounting measurement of future tax consequences for an enterprise. It is not tax levied by the government, but the amount calculated by application of the accrual concept. According to the latter, the tax effects of any transaction should be recorded in the same accounting period as the transaction itself.

US GAAP and tax rules differ regarding recognition and measurement of assets and liabilities. This results in permanent and temporary differences.

Permanent differences (foreign currency movements, fines, political donations, etc.) are never allowed for tax purposes. Therefore, no deferred tax on such differences is calculated.

Deferred tax assets or liabilities are only caused by temporary differences, the most common examples of which are listed below:

  • Depreciation is not deductable for tax purposes, but the cost of the related asset will be allowable  upon sale or liquidation of the asset;
  • A fixed asset is recorded at its fair value in consolidated financial statements, while it is carried at cost in financial statements of a single entity of the group;
  • Unrealized profit in inventory is eliminated for consolidation, yet it is taxed at the individual entity level;
  • Write down of slow-moving inventory in accounting is done while it is not allowed for tax deduction;
  • Development costs are capitalized and amortized in accounting, but deducted in full when incurred in tax computations;
  • Share-based compensation expenses are recognized in the income statement, while tax deductions are permitted only when share appreciation rights are exercised.
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