Deferring taxes
Corporations pay income taxes just like individuals do. It's reported as the final expense in the income statement. For example, in 2018, the final three lines in Exxon Mobil's income statement appeared like this, with all numbers shown in millions. The $9.532 billion in income tax expense reported by Exxon Mobil in 2018 is not necessarily equal to the amount of cash paid for income taxes during the year. In fact, Exxon Mobil paid cash of $9.294 billion for income taxes in 2018. The difference between reported income tax expense and the actual amount of cash paid for taxes arises for two reasons.
First, as with many other expenses, income taxes are not necessarily paid in cash in the year in which they are incurred. Because less cash than this was paid, there was an increase in the income taxes payable liability that remained at the end of 2018. Now in a similar fashion, individuals usually pay more or less income tax than they actually owe for a certain year, then the discrepancy is fixed the following year when they file their tax return and either pay additional tax or receive a tax refund. Now the second 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 government tax law. The $9.532 billion reported in 2018 reflects the total estimated amount of income tax expected to eventually be paid based on the income reported in the current year's income statement. However, because the income computed using the tax rules is almost always different from the income computed using financial accounting standards, some of this tax may not have to be paid for several years. In addition, tax rules may require income tax to be paid on income before the financial accounting standards consider that income to be earned. These differences in tax law income and financial accounting income give rise to deferred income tax items. Consider this example. Assume that you invest $1,000 by buying shares in a mutual fund on January 1st. Also assume that the income tax rate is 40%. According to the tax law, any economic gain you experience through an increase in the value of your mutual fund shares is not taxed until you actually sell your shares. The rationale behind this tax rule is that until you sell your shares, you don't have the cash to pay any tax. Now assume further that the economy does well and that the value of your mutual fund shares increases to $1,600 by December 31st. Now you should report the $600 gain in the income statement. But that gain is not taxed this year because you haven't sold the shares yet. If and when you liquidate the shares, you'll have to pay income tax of $240. It's the $1,600 value minus the $1,000 cost times the 40% tax rate. It would be misleading to report the $600 gain in your income statement without also reporting that at some future time, you will have to pay $240 in income tax on that gain. This $240 is called the deferred tax liability. Now note that the deferred tax liability is not a legal liability, because so far you do not currently owe any tax on the increase in the value of your mutual fund. However, the deferred tax liability is an economic liability that should be reported now, because it reflects an obligation that will have to be paid in the future as a result of an event, the increase in the value of the mutual fund shares, that occurred this year. Remember, reported income tax expense in the income statement reflects the total estimated amount of income tax expected to eventually be paid based on the income reported in the current year's income statement.