Updated July 19, 2023
Definition of Deferred Tax
Deferred tax refers to income tax overpaid or owed due to the temporary differences between accounting income and taxable income. It is part of the accounting adjustment and is eliminated over time as the temporary disparities are corrected. At the end of the fiscal year, it is recognized as a liability or an asset on the balance sheet.
Explanation
It arises due to temporary differences in accounting income and taxable income. Accounting income is income calculated before taxes per the prevailing standards, and taxable income is that portion of the total income subject to income tax as per the country’s tax laws or jurisdiction.
Temporary differences refer to the difference in the carrying amount of assets and liabilities in the statement of financial position and its tax base, i.e., the value of the purchase or liability that is subject to income tax as per the jurisdiction.
Formula
As per IAS 12- IFRS (International Financial Reporting Standards) following formula can be used to calculate deferred tax assets and deferred tax liabilities:
Examples of Deferred Tax
A typical example is the temporary differences arising due to different rates of depreciation used in income tax and books of accounts. Let’s know how asset or liability arises in the case of property, plant & equipment on account of the difference in rates of depreciation.
Deferred Tax Asset
The carrying amount of machinery per the accounts books after accounting for depreciation is $1,500. However, as per income tax, the carrying amount of the machinery is $1,800. Now, the tax base of the asset is $1,800, and the exact amount will be available as a deduction in income tax either by way of depreciation or otherwise as a cost deduction at the time of disposal.
Temporary Difference is calculated using the formula given below
Temporary Difference = Tax Base – Carrying Amount
- Temporary Difference= $1,800 – $1,500
- Temporary Difference= $300
Suppose the tax rate is 30%.
Deferred Tax Asset is calculated using the formula given below
Deferred Tax Asset = Tax Rate * Temporary Difference
- Deferred Tax Asset = 30% * $300
- Deferred Tax Asset = $90
Because the tax base exceeds the carrying amount, a deferred tax asset is calculated. The company has paid $90 in the current year, which can be offset against the excess tax burden that would arise when the timing discrepancy is reversed in the future when the company claims $300 in depreciation.
The accounting entry will be as follows:
Deferred Tax Asset Dr. $90
To Income Tax Payable Cr. $90
Deferred Tax Liability
Now suppose the situation is reversed, and the carrying amount of the asset as per the books is $1,800. The asset’s value, as per the income tax laws, is $1,500.
Here Tax Base = $1,500
Temporary Difference is calculated using the formula given below
Temporary Difference = Carrying amount – Tax Base
- Temporary Difference = $1,800 – $1,500
- Temporary Difference = $300
Suppose the tax rate is 30%.
Deferred Tax Liability is calculated using the formula given below
Deferred Tax Liability = Tax Rate * Temporary Difference
- Temporary Difference = 30% * $300
- Temporary Difference = $90
The accounting entry will be as follows:
Income Tax Expense Dr. $90
To Deferred Tax Liability Cr. $90
Deferred Tax in Accounting Standards
Accounting standards require companies to recognize liability or assets on the temporary timing differences. Income or expenses are included in accounting profit in one period but become part of taxable income or gain in a different period, resulting in timing differences.
IAS 12 promotes the IFRS (International Financial Reporting Standards) rules for calculating deferred tax.
SFAS 109 is utilized for deferred tax accounting purposes under US GAAP, and both standards, IFRS and US GAAP, are based on the approach of “temporary difference.”
Differences Between Deferred Tax and Taxable Temporary
It arises due to the temporary difference between accounting and taxable profits. Temporary differences can be classified into temporary taxable and deductible differences.
The temporary taxable difference gives rise to the taxable amount while calculating taxable profit/loss for future periods when the carrying amount of the assets and liabilities will be recovered or settled. A point to remember is that temporary taxable difference always gives rise to deferred tax liability.
Advantages
- According to the accrual basis of accounting, entities recognize liabilities or assets when they are incurred or calculated.
- This approach ensures that the financial position and adjusted profit after tax accurately reflect the company’s actual financial standing.
Conclusion
The calculation of deferred tax assets and liabilities typically occurs after determining the accounting profit. And the deferred tax mainly arises due to taxable and deductible temporary differences between accounting and taxable profits.
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