What is deferred tax?

It is a theoretical asset or obligation to imitate taxation of corporate income on a foundation that is the same or more similar to the recognition of profits than the treatment of tax. It is generally the effect of tax on the differences in timing.

Timing differences:

The dissimilarity between the book value and the taxable income or expense is the timing difference

Timing difference can either be :

  • Differences that are permanent. These are variances in the book income and tax income that do not reverse in any given period and therefore do not give rise to deferred tax. They arise from some types of income recognized in determining the accounting profits but no evaluated pretax purposes. For example gains on disposed of capital assets, windfall gains, donations, and grants especially if not related to business.
  • Certain types of expenditure documented in the determination of accounting profits but aren’t allowed as expenses for purposes of taxation. For example entertainment allowance not related to business from expenditure, loss on disposal of capital assets
  • Temporary differences. These are variances in the book income and tax income that reverse in the forthcoming periods and therefore resulting in deferred tax.

IAS 12 (Revised) defines temporary differences as variances between the assets or liabilities carrying amount in the financial position statement and the tax base that are not of a permanent nature.

Some differences arise when revenues and expenditures are incorporated in accounting profits in one period but are counted in the taxable profits in another period.

They are said to originate where there is a benefit in terms of tax savings arising. This means where the depreciation in tax is less than the depreciation in accounting. This implies a tax income.

Examples of the temporary timing difference:

  1. Interest revenue or expenses incorporated in the calculation of profits on the basis of accrual but incorporated in taxable profits on the basis of cash.
  2. Depreciation used in coming up with taxable profits may vary from the one used in coming up with the accounting profits
  3. Capitalization and amortization of development costs over future periods in defining the accounting profits but may be deducted in determining the taxable profits in the period in which they are suffered.

Deferred tax asset:

it is a firm’s financial position statement asset that can be used to reduce the taxable income.

It occurs where the firm has paid taxes in advance or overpaid them in the financial position statements.

The firm receives the refund of the overpaid taxes from the authorities as tax relief. The overpaid taxes, therefore, become an asset to the business.

Deferred tax is created were paid or carried forward taxes are not recognized in the income statement.

 Deferred tax assets can also arise where the rules of accounting differ from the rules of taxation.

For example, the existence of differed tax is due to the recognition of expenses in the income report before recognition by the tax authorities or when revenue is recognized as taxable in the income statement before it’s subject to taxes.

Deferred tax asset has an expiration date if not claimed. The most common expiration period is 20 years.

The tax rates’ effect on deferred tax assets is that if the tax rate rises the value of the asset also rises thus favouring the firm. If the tax rates lower then the worth of the asset decreases.

It is an increase in tax that is related to book proceeds and is estimated to occur in the future. It is generally the opposite of deferred tax liability

Deferred tax liability:

A DTL occurs where expenditure is deductible for purposes of taxation in the present period but is not deductible for book income until another forthcoming period, or when income is included in the books but not for taxable income until a forthcoming period.

The reasons for deferred tax liability are:

  1. Differences that arise due to the timing of revenue and recognition of expenses in the income statement and tax return.
  2. Recognition of various expenses and revenue in the tax return but not in the income statement
  3. Variances in the recognition of gain and loss in the income statement and tax return.
  4. Different carrying amounts and tax bases of liabilities and assets
  5. Future income which is taxable may be offset by losses from previous periods.
  6. Adjustments of financial statements may not influence the tax return and the period for recognition may be different.

When recognition of revenue and expenditures in the income report occur before they are taxable then deferred tax liability is created.

Deferred tax asset is caused by temporary differences and thus reversible.it results in future cash flows when the taxes are paid.

Generally, the deferred tax liability is the amount of tax that the firm has underpaid and which will be made in the future.

Temporary differences

The reverse in the foreseen period and thus give rise to deferred tax.

Temporary differences = carrying amounts of assets or liabilities NBV – tax base of assets or liabilities written down values 

The carrying amount of assets or liabilities is the value of such asset or liability as per the draft of financial reports.

The tax base of an asset

This is the deductible amount for purposes of taxation against any economic taxable benefit factor that will flow to the firm when it recovers the asset carrying amount. This generally means the amount in which future capital allowances will be based.

The tax base of a liability

This is the carrying amount of liability reduced by any amount that will be deductible or allowable for purposes of taxation in relation to that liability in the forthcoming periods.

The tax base of a liability = carrying amount – amounts deductible for tax purposes in respect of liability in future

Type of temporary difference

Some items are not recognized as assets or liabilities though they have a tax base For example costs related to research are documented as an expense in the determination of the firm’s profit in the period in which they are suffered but may not be tolerable as allowable expense in determination of profit that is taxable until a later date. This gives rise to a temporary difference

Temporary differences that may arise include

  • Taxable temporary differences. They are differences that will result in taxable amounts in the future when the carrying amounts of assets are recovered or the liabilities are settled. They give rise to deferred tax liability at the end of the year. 
  • arise when;
  • The carrying amount of assets exceeds its tax base
  • The carrying amounts of liabilities are less than their tax base.
  • Deductible tax differences. They are differences that will result in sums that are tax-deductible in the forthcoming periods when the carrying amounts of assets are recuperated or liabilities are settled.
  • arise when;
  • The carrying amounts of assets are less than their tax bases
  • The carrying amount of liabilities exceed their tax bases

Deferred Tax Assets

Definition:

Deferred tax asset arises when differences exist between the taxable income and actual income of a company. In other words, it is the amount of money the IRS owes to you because your taxable income was higher than your actual income for a particular accounting period and hence, you paid higher taxes than you reported on your books as per the accrual system.

Explanation:

Usually, the tax authorities have a different set of rules for the calculation of taxable income.

It calculates the taxable income on the cash basis, irrespective of the matching concept of accounting, and the tax is then charged at such taxable income.

This amount of tax calculated on cash income is the income tax expense payable for the year whereas the tax expense incurred on actual accounting income is referred to as current tax expense for the year and is reported on the income statement.

The variation arises due to time differences in expenses or incomes. For example, accounts payable (credit purchases) of the year would be added back into actual income to arrive at taxable income, causing the taxable income to be higher than the actual income.

The tax charged would be higher than the current tax expense for the year due to a deductible temporary difference.

However, when in the future, the company actually settles the creditors’ debts, the deferred tax shall be recovered as the creditor’s balance will be deducted from the taxable income.

Income tax payable is calculated as follows:

Particulars $
Accounting income xxx
(+/-) Temporary differences xx/(xx)
(+/-) Permanent differences xx/(xx)
Taxable Income xxx
 Tax rate X %
Income tax payable xx

Hence, deferred tax asset arises when the tax payable is higher than the tax expense incurred by the company. It is the excess amount of cash paid to the government in the name of tax.

The journal entry passed to record deferred tax asset is as follows:

Deferred Tax Asset                                                                      DR

Current Tax Expense (accounting profit*tax rate)           DR

          Income Tax Payable (taxable income*tax rate)       CR      

Reasons why the deferred tax asset arises:

  • A deferred tax asset would arise when the depreciation method, as per tax laws, is straight line whereas you have used a double depreciation method in your books of accounts. As double depreciation method charges higher depreciation in initial years, the accounting income is lower than the taxable income resulting in a deferred tax asset.
  • When a higher depreciation rate for your books is used than the tax laws’, a higher depreciation is charged on the accounts whereas a lower depreciation is charged to the taxable income.
  • Accrued expenses such as rent payable may cause a deferred tax asset as well. Rent incurred is deducted on the income statement whereas on the tax statement, only rent paid is deducted; hence, causing a deferred tax asset.
  • When an advance income is received, it is included in the tax statement and not on the income statement. Hence, the accounting profit is lower and taxable profit is higher; there is a deductible temporary difference resulting in a deferred tax asset.
  • Provision for bad debt is a line item of income statement whereas it is not considered as expenditure under the tax laws and is added back. Hence the taxable income is higher than accounting income resulting in deferred tax asset.

Example:

ABC Company has bought machinery for $50,000. It depreciates its assets at the rate of 20% per annum whereas the tax laws allow depreciation at 10% per annum. It also has a net profit of $80,000 for the current year and a 30% tax rate.

Particulars $
Accounting Income 80,000
(+) Accounting depreciation 10,000
(-) Tax depreciation (5,000)
Taxable Income 85,000
 Tax rate  30%
Income Tax payable 25,500

Journal Entry:

Current Tax Expense ($80,000*30%)   $24,000

Deferred Tax Asset           $1,500

                                    Income Tax Payable ($85,000*30%)    $25,500

Deferred tax liability

Definition:

Deferred tax liability can be defined as an income tax liability to the IRS, for having tax payable less than what you actually incurred due to temporary differences between accounting income and taxable income.

It is a line item booked under the liability section of the balance sheet of a company. 

In other words, deferred tax liability arises when you pay lesser tax to the government than you actually incurred and owed as per the accrual basis of accounting. 

Explanation:

The Financial Accounting Standards Boards (FASB) requires companies to make financial statements as per the generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS).

Hence, the net profit for the year, calculated on the income statement, is calculated and prepared as per the IFRS and GAAP.

On the other hand, the tax officials calculate the annual income on the cash basis of accounting. As per the income tax act, there are some expenses that are allowed to be deducted while others are not.

These restrictions generate a difference between the accounting income and the taxable income, resulting in deferred taxes. 

  • When the accounting income is more than taxable income, resulting in a temporary taxable difference, the tax payable amounts to be less than the tax incurred as per the accrual basis of accounting.
  • When the accounting income is less than the taxable income, resulting in a temporary deductible difference, the tax payable amounts to be more than the tax incurred as per the accrual basis of accounting.

In case of a temporary deductible difference, deferred tax asset arises, whereas in case of a temporary taxable difference, deferred tax liability arises. 

Income tax payable is calculated as follows:

Particulars $
Accounting income xxx
(+/-) Temporary differences xx/(xx)
(+/-) Permanent differences xx/(xx)
Taxable Income xxx
 Tax rate X %
Income tax payable xx

Current tax expense = Accounting profit Tax rate

Deferred Tax Liability = Current tax expense – Income tax payable (when accounting income is higher than taxable income)

The journal entry passed to record deferred tax liability is as follows:

Current Tax Expense (accounting profit*tax rate) DR

Income Tax Payable (taxable income*tax rate) CR 

Deferred Tax Liability CR

Reasons why deferred tax liability arises:

  • A deferred tax liability may arise in the early years of a purchase of a machine in case the company’s depreciation method is a straight line as compared to the tax law’s double depreciation method. Due to the double depreciation method, higher depreciation would be charged on the tax statement resulting in lower taxable income than the accounting income resulting in deferred tax liability.
  • Similarly, a higher depreciation rate used by tax authorities as compared to the lower rates used by the company would lead to lower taxable income resulting in a low tax charge for the year even if the tax incurred is higher.
  • Advance payments may also lead to deferred tax liability. Advance rent paid by a company does not get reported on the income statement; however, on the tax statement, it gets deducted, resulting in a lower taxable income than the accounting income. A temporary taxable difference arises, resulting in a deferred tax liability.
  • The credit sales are reported as revenue n the income statement, whereas the tax statement only includes cash sales, resulting in a higher accounting income and lower taxable income. Hence, deferred tax liability would arise that is to be satisfied in the accounting period when the receivables clear their dues.

Example:

ABC Company has $20,000 worth of credit sales for the year and a net profit of $160,000. Its tax rate is 30%. Prepare the journal entry to recognize deferred taxes.

Particulars $
Accounting Income 160,000
(-) Credit Sales (20,000)
Taxable Income 140,000
 Tax rate  30%
Income Tax payable 42,000

Journal Entry:

Current Tax Expense ($160,000*30%) DR $48,000

                  Income Tax Payable ($140,000*30%) CR $42,000

                Deferred Tax Liability CR $6,000