Introduction:

A statement of cash flow is part of the annual financial statements that are presented by an entity along with the statement of financial position, statement of comprehensive income and statement of changes in equity.

It represents the net cash flow (cash generated less cash spent) of an entity during a specific period (i.e. a month, a quarter, or year) which is arrived at by adjusting the profit before tax for the year. This is done by excluding any future cash inflows or outflows that are recorded as credit for the current year.

Cash Flow Elements:

Cash flow statement constitutes of three main parts which are presented in the following order:

  • Operating activities
  • Investing Activities
  • Financing Activities

The profit or loss before tax is adjusted by converting the items that are reported in the income statement on accrual basis to cash basis in the operating activities section, giving us the amount of total cash flow from operating activities.

Example:

An entity has an increase in its trade receivables amounting to $1000 which is also included in the net profit of the company as a credit sale.

This shall be adjusted in the operating activities section of the cash flow statement by deducting the credit amount of $1000 from the net profit or loss in order to get one step closer to the net cash flow for the year.

Treatment of deferred Tax in Operating Activity:

Similarly, deferred tax is a non-cash item and shall be treated accordingly in the operating activities section of the cash flow statement.

A deferred tax asset arises when the carrying value of an asset is less than its tax base or carrying value of any liability is more than its tax base creating a deductible temporary difference.

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Whereas, a deferred tax liability arises when the carrying value of an asset is more than its tax base or the carrying value of a liability is less than its tax base resulting in a taxable temporary difference.

Any increase in the deferred tax asset or decrease in deferred tax liability shall be subtracted from the profit or loss before tax for the year.

Whereas, any decrease in deferred tax asset and increase in deferred tax liability shall be added to the net profit or loss.

Example:

The carrying value of trade receivables for the year ended 2019 is $3000 and 2018 is $5000 whereas the tax base for the year 2019 is $5000 and 2018 is $6000. The tax rate is 30%.

In 2018, a deductible difference of $1000 would arise because the carrying value ($5000) of the asset is less than its tax base ($6000). This would result in a deferred tax asset of $300 i.e. $1000 x 30%.

Likewise, in 2019 a deferred tax asset of $600 ($2000 x 30%) would arise due to a deductible difference of $2000 ($5000 – $3000) for the year.

Now, the increase in deferred tax asset of $300 which is the difference between the opening ($300) and closing ($600) deferred tax amount would be subtracted from the net profit or loss in the operating activities section and the vice versa would happen in case of a decrease in deferred tax asset or increase in deferred tax liability.

Conclusion:

The logic behind it is that, in the year 2019 the tax expense on the accounting profit would be less than the tax expense on taxable profit. Since, tax for the year is paid as per the taxable profit we would be paying a greater amount of tax than is accrued according to the accounting policies.

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Hence, this tax that we paid in “advance” is referred to as deferred tax asset and will be adjusted in later years by debiting the deferred tax income and crediting the current tax year expense.