Definition
Deferred tax is a term used in accounting to refer to the differences between the tax basis of an asset or liability and its carrying value in the financial statements. These differences arise due to the differences in accounting methods used for tax purposes and financial reporting purposes.
When the tax basis of an asset or liability is higher than its carrying value, a deferred tax liability is created. This means that the company will have to pay more in taxes in the future when the asset is sold or the liability is settled.
On the other hand, when the tax basis of an asset or liability is lower than its carrying value, a deferred tax asset is created. This means that the company will pay less in taxes in the future when the asset is sold or the liability is settled.
Deferred tax can arise from a variety of transactions, such as depreciation, amortization, inventory valuation, and employee benefits. It is important for companies to account for deferred tax to ensure that their financial statements accurately reflect their tax liabilities and assets.
Deferred tax is typically calculated using the tax rate that is expected to be in effect in the year when the difference between the tax basis and carrying value is expected to reverse.
This requires a significant amount of judgment, as tax laws and rates can change over time. Companies must disclose their deferred tax assets and liabilities in their financial statements, along with a detailed explanation of how they were calculated.
Timing differences:
The dissimilarity between the book value and the taxable income or expense is the timing difference
Timing difference can either be :
- Permanent differences. These variances in the book income and tax income do not reverse in any given period and 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 unrelated to business.
- Certain types of expenditure are documented in determining accounting profits but aren’t allowed as expenses for taxation purposes. For example, entertainment allowance not related to business from expenditure, loss on disposal of capital assets.
- Temporary differences. These variances in the book income and tax income reverse in the forthcoming periods, 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 permanent.
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 tax savings. This means that the depreciation in tax is less than the depreciation in accounting. This implies a tax income.
Examples of the temporary timing difference:
- Interest revenue or expenses are incorporated in the calculation of profits based on accrual but taxable profits are based on cash.
- Depreciation used in generating taxable profits may vary from the one used to generate the accounting profits.
- Capitalization and amortization of development costs over future periods in defining the accounting profits may be deducted in determining the taxable profits in the period they suffer.
Deferred tax asset:
It is a firm’s financial position statement asset that can be used to reduce taxable income. It occurs when 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 accounting rules differ from those of taxation.
For example, the existence of differed tax is due to the recognition of expenses in the income report before the tax authorities recognize them 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 asset value also rises, thus favoring the firm.
If the tax rates are 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 when expenditure is deductible for taxation purposes in the present period but not 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:
- Differences arise due to the timing of revenue and recognition of expenses in the income statement and tax return.
- Recognition of various expenses and revenue in the tax return but not in the income statement
- Variances in the income statement and tax return recognition of gain and loss.
- Different carrying amounts and tax bases of liabilities and assets
- Losses from previous periods may offset future income, which is taxable.
- Adjustments of financial statements may not influence the tax return, and the period for recognition may be different.
When revenue recognition and expenditures in the income report occur before they are taxable, the deferred tax liability is created.
Deferred tax asset is caused by temporary differences and is thus reversible. It results in future cash flows when the taxes are paid.
Generally, the deferred tax liability is the amount of tax the firm has underpaid and 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 per the draft of financial reports.
The tax base of an asset
This is the deductible amount for taxation purposes against any economic taxable benefit factor that will flow to the firm when it recovers the asset-carrying amount.
This generally means the amount on which future capital allowances will be based.
The tax base of a liability
This is the carrying amount of liability reduced by any deductible or allowable for taxation purposes with 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 determining the firm’s profit in the period in which they suffered but may not be tolerable as an allowable expense in determining 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 tax-deductible sums 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 exceeds their tax bases
How Is Deferred Tax Assets and Liabilities Affect the Statement of Change in Equity?
Deferred tax assets and liabilities can affect the statement of changes in equity in a number of ways. A deferred tax asset is an income tax benefit that a company has not yet recognized in its financial statements but expects to recognize in the future.
It arises from temporary taxable differences between the tax basis of an asset or liability and its carrying amount in the financial statements.
If a company has deferred tax assets, it has overpaid its taxes and expects to receive a tax refund.
On the other hand, a deferred tax liability is a tax obligation that a company has not yet recognized in its financial statements but expects to recognize in the future.
It arises from temporary taxable differences between the tax basis of an asset or liability and its carrying amount in the financial statements.
If a company has deferred tax liabilities, it has underpaid its taxes in the past and expects to pay more taxes in the future.
The effect of deferred tax assets and liabilities on the statement of changes in equity depends on the timing and amount of the recognition of these tax benefits and obligations in the financial statements.
For example, if a company recognizes a deferred tax asset in its financial statements, it may increase net income and equity.
On the other hand, if a company recognizes a deferred tax liability in its financial statements, it may decrease net income and equity.
Therefore, deferred tax assets and liabilities can significantly impact a company’s financial performance and equity position.
Companies should carefully manage and monitor their deferred tax assets and liabilities to ensure that they are accurately reflected in their financial statements.
How Are Deferred Tax Assets and Liabilities Reported in the Statement of Cash Flow?
Deferred tax assets and liabilities are not directly reported in the statement of cash flows, as the statement of cash flows only reports inflows and outflows of cash and cash equivalents.
However, deferred tax assets and liabilities can indirectly impact the statement of cash flows as they may impact the net income reported in the income statement, which is used in the calculation of the cash flow from the operating activities section of the statement of cash flows.
For example, if a company has deferred tax assets and reports a taxable income in the future, the deferred tax assets will reduce the taxable income, increasing the net income.
This, in turn, can impact the cash flow from operating activities, as an increase in net income can lead to increased cash generated from operations.
Similarly, if a company has deferred tax liabilities, an increase in taxable income in the future may increase the taxable liability, reducing the net income.
This reduction in net income can negatively impact the cash flow from operating activities, as the cash generated from operations may decrease.
