The role of deferred tax in financial reporting and tax planning is crucial, as it shows temporary differences between accounting income and taxable income. In essence, it occurs when taxes are either paid in advance or deferred to future periods because of differences in the way transactions are recognized for financial accounting versus tax purposes.

Deferred tax can be classified into two main types: When a company pays more tax upfront than required or has temporary differences that reduce future taxable income, they have deferred tax assets. Carryforward losses or expenses that are recognized earlier for tax purposes than in accounting records are some examples.

Deferred tax liabilities: Tax obligations that a company will need to pay in the future create these issues. Revenue is generally recognized earlier for accounting purposes than for tax purposes.

Here's an instance of deferred tax in action:

Imagine a company named XYZ Corp. that buys machinery for $100,000. XYZ Corp. uses the straight-line method to depreciate the machinery over five years for accounting purposes, resulting in an annual depreciation expense of $20,000 reported in its financial statements.

XYZ Corp. can use an accelerated depreciation method thanks to tax regulations, which enables them to claim higher depreciation deductions in previous years. In the first year, XYZ Corp. takes advantage of $40,000 in depreciation to pay taxes.

Here's where deferred tax comes into play:

This is where deferred tax comes into play:

• The financial statements show a depreciation expense of $20,000.
• By deducting $40,000 from its tax return, XYZ Corp. reduces its taxable income and taxes paid for the current year.
• In the future, the company will have to pay higher taxes as it will have lower depreciation expenses for tax purposes in later years.
• Due to postponing some of its tax payments to future years, the company will have a deferred tax liability.