Deferred Income Tax

Definition of Deferred Income Tax

Deferred Income Tax is the taxes applicable on the taxable income of the entity which is payable in the future years as they are not due for payment in the current financial year, which arises because of the difference in the tax amount reported in the accounting framework opted by the company and the tax amount reported in the taxation regime of the local tax authorities.

Explanation

Sometimes due to different regulations and rules followed in the tax regime and accounting framework, some taxable proportion is reported, and tax liability on the same is reported in the company’s financials. Still, tax is not due in that reporting period as per the regulations of the tax authorities. The same will be payable in other financial periods or reporting periods. However, tax is not to be paid in the current reporting period; the liability of the exact needs to be created because the tax is to be paid in the future period. This is known as deferred income tax and needs to be reported in the company’s financial statement for an accurate and fair view of the financials.

Example of Deferred Income Tax

Let’s take an example for more clarity.

Suppose a company has a fixed asset costing $ 50000.00. As per International accounting standards in the accounting framework, the depreciation is to be charged at the rate of 10% per annum as per the straight-line method, which amounts to $ 5000.00 per annum, and the same will be reported in the financials of the company. But as per the income tax regime, the company is only allowed to charge depreciation through a weighted average method which comes to the rate of 10% per annum, amounting to $ 7500.00. Hence the company’s profit is undervalued by $ 2500.00, and the company has to pay less tax than the tax calculated in the financial statement. However, the tax on the amount of $ 2500.00 will need to be paid in the future; hence, liability for the same should be recognized in the company’s financial statements.

Deferred Income Tax on the balance sheet

As explained above, the deferred income tax must be presented in the entity’s financial statements. It should be noted that the main reason for the creation of deferred tax assets or liability is due to the difference arising due to a temporary timing difference, as the same would be reversed in the future. In case the scenario occurs where due to a quick time difference, the assesse has to pay low taxes at the current time but may have to pay high taxes later in the future, deferred tax liability should be created in the year by appropriating the profit & loss of that year of the company. The deferred tax liability will be presented in the Non-current liability schedule of the balance sheet. But if the scenario indicates that the current taxable profit is more than that of book profit, then that deferred tax asset should be created, and the same should be presented in the non-current asset schedule of the balance sheet.

Deferred Income Tax Journal Entry

Following are the Journal entries to be booked in case of deferred tax cases-

• In Case of Deferred Tax Liability

When book profit is more than the taxable profit, deferred tax liability must be created in the company’s financials. The following journal entries should be booked-

• In Case of Deferred Tax Assets

When book profit is less than the taxable profit, deferred tax assets must be created in the company’s financials. Following journal entries should be booked-

Deferred Income Tax vs Deferred Tax Liability

Following are the key differences between the deferred tax assets & deferred tax liabilities:

• When the book profit of the assesse is more than the taxable profit as per income tax rules, that here deferred tax liability is created; in contrast, when the book profit of the assesse is less than the taxable profit as per income tax rules, deferred tax assets are made here.
• The deferred tax liability indicates that the current year’s tax liability is more than compared to the financials of the assesse, which means the assesse has to pay more taxes in the future, which results in the creation of liability or provisions. In contrast, deferred tax assets indicate that the current year’s tax liability is less than the financials of the assesse, which means the assesse has to pay more in the current year and less in the later years.

Benefits

Following are the benefits of the deferred income tax:

• It provides an accurate & fair view of the financials by accommodating certain future liabilities or benefits that will arise for the company.
• The deferred income tax procedures help validate the tax liability of the company’s financials per the company’s acts and accounting frameworks, with the tax liability arising per the income tax rules.

Disadvantages

Following are the disadvantages of the deferred income tax:

• Mostly the users of the financial statements are common people for whom the deferred tax rules are complicated, and they may not understand the purpose and the reason for the same.
• In the case of deferred tax assets, the company may have to bear a substantial increase in actual tax liabilities, which may have a considerable effect on the financial output of the company for the fiscal year.

Conclusion

It provides the methods for the assesse to deal with the differences arising in the tax liability of the assesse as per the accounting frameworks and the local income tax rules due to the temporary time differences. The temporary time differences result in deferred income tax as the situation is reversed in the future, but permanent time differences will not result in deferred income tax.

Recommend ed Articles

This is a guide to Deferred Income Tax. Here we also discuss the definition and example of deferred income tax along with its benefits and disadvantages. You may also have a look at the following articles to learn more –

1. Tax Shelter
2. Tax Evasion vs Tax Avoidance
3. Statement of Cash Flows
4. Solvency Ratio