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 gets eliminated as the temporary differences are reversed over time. It is recorded as a liability or asset in the balance sheet at the year-end.
Explanation
Deferred tax arises due to temporary differences in accounting income and taxable income. Accounting income is income calculated before taxes as per the prevailing standards and taxable income is that portion of the total income which is subject to income tax as per the tax laws of the country 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. value of the asset or liability that is subject to the income tax as per the jurisdiction.
Formula for Deferred tax
As per IAS 12- IFRS (International Financial Reporting Standards) following formula can be used to calculate deferred tax asset and deferred tax liabilities:
Examples of Deferred Tax
A common example that is used for understanding deferred tax is of temporary differences arising due to different rates of depreciation used in income tax and books of accounts. Let’s understand how deferred tax asset or liability arises in case of property, plant & equipment on account of difference in rates of depreciation.
Deferred Tax Asset
The carrying amount of machinery as per the books of accounts 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 as the same amount will be available as a deduction in income tax either by way of depreciation or otherwise as 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
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Deferred Tax Asset = Tax Rate * Temporary Difference
- Deferred Tax Asset = 30% * $300
- Deferred Tax Asset = $90
Here deferred tax asset is calculated since the tax base exceeds the carrying amount. The company has paid $90 in the current year which can be adjusted against the excess tax liability as per books of accounts which will arise as the timing difference gets reversed in the future when the company claims depreciation of $300. 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 value of the asset 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 deferred tax liability or asset on the temporary timing differences. Timing differences arise when income or expense is included in accounting profit in one period but they are included in taxable profit in the other period.
As per IFRS (International financial reporting standards), IAS 12 advocates the principles for the calculation of deferred tax, and as per US GAAP – SFAS109 is used for deferred tax accounting purposes and both are based on the approach of “temporary difference”.
Differences between Deferred Tax and Taxable Temporary
Deferred tax arises due to the temporary difference in accounting profit and taxable profit. Temporary differences can be further classified into taxable temporary differences and deductible temporary differences.
The taxable temporary difference gives rise to taxable amount while calculating taxable profit/loss for the future periods when the carrying amount of the assets and liabilities will be recovered or settled. A point to remember is that taxable temporary difference always gives rise to deferred tax liability.
Advantages of Deferred Tax
- As per the accrual basis of accounting, deferred tax liability or asset should be recognized in the period they are calculated which helps in showing the actual financial position and adjusted profit after tax.
- In case of future tax consequences i.e. deferred tax asset/ liability is not recognized in books of accounts, it will lead to an overstatement of profit and overpayment of dividends, etc.
Conclusion
Deferred tax is required to be calculated as per accounting standards. The calculation of deferred tax asset and liability is done after the calculation of accounting profit. And the deferred tax mainly arises due to taxable and deductible temporary differences between accounting and taxable profits.
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