It is a theoretical asset or obligation to imitate corporate income taxation on a foundation that is the same or more similar to the recognition of profits than tax treatment. It is generally the effect of tax on the differences in timing.
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 not related 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 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:
- Interest revenue or expenses incorporated in the calculation of profits based on accrual but incorporated in taxable profits based on cash.
- Depreciation used in coming up with taxable profits may vary from the one used in coming up with 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 in which they are suffered.
Deferred tax asset:
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 where 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 the tax authorities recognize 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 where expenditure is deductible for taxation purposes 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:
- 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 recognition of gain and loss in the income statement and tax return.
- 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 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.
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 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 are 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 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