Some events result in taxes being paid now, and some events result in taxes being paid in the future. Learn about which events give rise to deferred taxes, and how those taxes are reported on the financial statements.
- Exxon Mobil is a huge oil and gas company. They pump oil out of the ground and through various processes, the end result is the gas goes in our tanks so that we can get from point A to point B. For 2016, Exxon Mobil reported total revenues of over $226 billion. They reported net income of $7.8 billion. And their income tax expense for the year, a negative 406 million. In other words, they did not report income tax expense for 2016.
They reported the opposite of that. How can that be? At the same time during 2016, Exxon reported that they paid $4.2 billion in income tax. Well, I'm confused. How can they report negative tax expense when they report almost $8 billion in net income and pay over $4 billion to various governments as income tax? Well, the answer will make perfect sense, hopefully, with a little more information. Now, a primary reason for a difference between reported income tax expense and the actual amount of cash paid for taxes is that income tax expense is based on reported financial accounting income, whereas the amount of cash paid for income taxes is dictated by the applicable governmental tax laws.
Corporations in the United States compute two different income numbers: financial income for reporting to stockholders and taxable income for reporting to the Internal Revenue Service. The existence of these two sets of books seem unethical to some, illegal to others. However, the difference between the information needs of the stockholders and the efficient revenue collection needs of the government makes the computation of these two different income numbers essential. The different purposes of these reporting systems were summarized by the US Supreme Court in the Thor Power Tool Case in 1979.
The opinion read: The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system, in contrast, is the equitable collection of revenue. In summary, US corporations compute income in two different ways, and rightly so. But the existence of these two different numbers that can each be called income before taxes makes it surprisingly difficult to define what is meant by income tax expense.
Differences between accounting income and taxable income can be classified into what are called permanent and temporary differences. Permanent differences enter into the determination of accounting income, but never into the determination of taxable income. An example of a permanent difference is interest on state and local bonds. Although interest on these items represents revenue from a financial accounting perspective, it's not included in taxable income in either the year received or the year earned.
Temporary differences are what commonly give rise to differences between taxable income and financial accounting income. These temporary differences also can result in what are called deferred tax assets and deferred tax liabilities. Temporary differences result from the fact that some transactions affect taxable income in a different period than the one in which they affect pretax financial accounting income. Over the life of a particular transaction, the total amount of income or expense for accounting and tax purposes is the same, but the amounts reported from year to year may differ.
Consider the case of depreciation, probably the most common reason for differences between book and tax income. Companies recognize depreciation expense each year to represent the wearing out of long-term assets such as buildings and machinery as they are used in operations. We knew that. The amount of depreciation is typically computed differently for financial accounting purposes and for income tax reporting purposes. In fact, the income tax laws are written so that companies can report a large amount of depreciation expense in the early years of the life of a long-term asset.
This rapid depreciation allows a company to reduce its taxable income and its income tax payments in the early years of the life of an asset, thus making it easier to buy the building or machinery in the first place. The effect of this rapid tax depreciation is to temporarily shield some of the company's income from taxation by providing for temporarily high-depreciation deductions after long-term assets are purchased. Ultimately, the high depreciation deductions will run out in future years and income tax on the temporary shielded income will have to be paid.
Exxon Mobil, for example, has recorded a deferred tax liability relating to its temporary timing differences associated with the difference between financial accounting depreciation and tax depreciation of over $46 billion. They know that some day those temporary differences will reverse and they will owe. The amount they will some day pay is on their books as a liability resulting from deferred tax timing differences. Another common temporary difference is recording pension expense for employees in the period in which they work and deducting payments to those employees when they retire.
These temporary differences make sense and they result in differences between financial accounting income reported to financial statement users and taxable income reported to government agencies. These temporary timing differences are one of the reasons Exxon Mobil reports no income tax expense in 2016 on their income statement, but why they wrote checks out to various government agencies of over $4 billion during that same period. I'm grateful my taxes aren't that complicated.
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