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Accountancy
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Key concepts
Accountant · Bookkeeping · Trial balance · General ledger · Debits and credits · Cost of goods sold · Double-entry system · Standard practices · Cash and accrual basis · GAAP / IFRS
Financial statements
Balance sheet · Income statement · Cash flow statement · Equity · Retained earnings
Auditing
Financial audit · GAAS · Internal audit · Sarbanes–Oxley Act · Big Four auditors
Fields of accounting
Cost · Financial · Forensic · Fund · Management · Tax

Deferred tax is an accounting concept (also known as future income taxes), meaning a future tax liability or asset, resulting from temporary differences between the accounting value of assets and liabilities and their value for tax purposes.

Contents

Temporary differences

Temporary differences are differences between the carrying amount of an asset or liability recognized in the balance sheet and the amount attributed to that asset or liability for tax purposes (the tax base)[1].

Temporary differences may be either:

  • taxable temporary differences, which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled; or
  • deductible temporary differences, which are temporary differences that will result in deductible amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled[1].
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Tax base

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes:

  • the tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset.
  • the tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods.

Illustrated example

The basic principle of accounting for deferred tax under a temporary difference approach can be illustrated using a common example in which a company has fixed assets which qualify for tax depreciation.

The following example assumes that a company purchases an asset for $1,000 which is depreciated for accounting purposes on a straight-line basis of five years. The company claims tax depreciation of 25% per year on a declining balance basis. The applicable rate of corporate income tax is assumed to be 35%.

Purchase Year 1 Year 2 Year 3 Year 4
Accounting value $1,000 $800 $600 $400 $200
Tax value $1,000 $750 $563 $422 $316
Taxable/(deductible) temporary difference $0 $50 $37 $(22) $(116)
Deferred tax liability/(asset) at 35% $0 $18 $13 $(8) $(41)

As the tax value (tax base) is lower than the accounting value (net book value) in years 1 and 2, the company should recognise a deferred tax liability. This also reflects the fact that the company has claimed tax depreciation in excess of the expense for accounting depreciation recorded in its accounts, whereas in the future the company should claim less tax depreciation in total than accounting depreciation in its accounts.

In years 3 and 4, the tax value exceeds the accounting value, therefore the company should recognise a deferred tax asset (subject to it having sufficient forecast profits so that it is able to utilise future tax deductions). This reflects the fact that the company expects to be able to claim tax depreciation in the future in excess of accounting depreciation.

Timing differences

Whereas International Financial Reporting Standards and US GAAP adopt a balance sheet approach in relation to deferred tax focused on temporary differences, certain GAAPs such as UK GAAP require deferred tax to be instead recognised in respect of timing differences.

A timing difference arises when an item of income or expense is recognised for tax purposes but not accounting purposes, or vice versa, and is therefore consistent with a profit and loss approach to deferred tax.

In many cases the deferred tax outcome will be similar for a temporary difference or timing difference approach. However, differences can arise such as in relation to revaluation of fixed assets qualifying for tax depreciation, which gives rise to a deferred tax asset under a balance sheet approach, but in general should have no impact under a timing difference approach.

Justification for deferred tax accounting

Deferred tax is recognized as a result of the Matching principle. Deferred tax liabilities are provided in order that investors may understand the future tax liabilities that may arise as a result of accelerated tax relief taken to date, or income that has not yet been taxed.

Where accelerated tax relief is obtained for expenditure relative to the timing of an expense recognized in a company's profit and loss account, a deferred tax charge should be recognized in the profit and loss account for the movement in the company's deferred tax liability, which will increase the company's total tax charge.

Examples

Deferred tax liabilities

Deferred tax liabilities generally arise where tax relief is provided in advance of an accounting expense, or income is accrued but not taxed until received. Examples of such situations include:

  • a company claims tax depreciation at an accelerated rate relative to accounting depreciation
  • a company makes pension contributions for which tax relief is provided on a paid basis, whereas accounting entries are determined in accordance with actuarial valuations

Deferred tax assets

Deferred tax assets generally arise where tax relief is provided after an expense is deducted for accounting purposes.Examples of such situations include:

  • a company may accrue an accounting expense in relation to a provision such as bad debts, but tax relief may not be obtained until the provision is utilised
  • a company may incur tax losses and be able to "carry forward" losses to reduce taxable income in future years

Deferred tax in modern accounting standards

Modern accounting standards typically require that a company provides for deferred tax in accordance with either the temporary difference or timing difference approach. Where a deferred tax liability or asset is recognised, the liability or asset should reduce over time (subject to new differences arising) as the temporary or timing difference reverses.note

Under International Financial Reporting Standards, deferred tax should be accounted for using the principles in IAS 12: Income Taxes, which is similar (but not identical) to SFAS 109 under US GAAP. Both these accounting standards require a temporary difference approach.

Other accounting standards which deal with deferred tax include:

Derecognition of deferred tax assets and liabilities

Management has an obligation to accurately report the true state of the company, and to make judgements and estimations where necessary. In the context of tax assets and liabilities, there must be a reasonable likelihood that the tax difference may be realised in future years.

For example, a tax asset may appear on the company's accounts due to losses in previous years (if carry-forward of tax losses is allowed). In this case a deferred tax asset should be recognised if and only if the management considered that there will be sufficient future taxable profit to utilise the tax loss.[2] If it becomes clear that the company does not expect to make profits in future years, the value of the tax asset has been impaired: in the estimation of management, the likelihood that this tax loss can be utilised in the future has significantly fallen.

In cases where the carrying value of tax assets or liabilities has changed, the company may need to do a write down, and in certain cases involving in particular a fundamental error, a restatement of its financial results from previous years. Such write-downs may involve either significant income or expenditure being recorded in the company's profit and loss for the financial year in which the write-down takes place.

See also

Notes

  1. ^ a b IAS 12.5
  2. ^ IAS 12.34

External links


Accountancy
Key concepts

Accountant

  1. REDIRECT template:· Bookkeeping
  2. REDIRECT template:· Cash and accrual basis
  3. REDIRECT template:· Constant Item Purchasing Power Accounting
  4. REDIRECT template:· Cost of goods sold
  5. REDIRECT template:· Debits and credits
  6. REDIRECT template:· Double-entry system
  7. REDIRECT template:· Fair value accounting
  8. REDIRECT template:· FIFO & LIFO
  9. REDIRECT template:· GAAP / International Financial Reporting Standards
  10. REDIRECT template:· General ledger
  11. REDIRECT template:· Historical cost
  12. REDIRECT template:· Matching principle
  13. REDIRECT template:· Revenue recognition
  14. REDIRECT template:· Trial balance
Fields of accounting

Cost

  1. REDIRECT template:· Financial
  2. REDIRECT template:· Forensic
  3. REDIRECT template:· Fund
  4. REDIRECT template:· Management
  5. REDIRECT template:· Tax
Financial statements

Balance sheet

  1. REDIRECT template:· Statement of cash flows
  2. REDIRECT template:· Statement of changes in equity
  3. REDIRECT template:· Statement of comprehensive income
  4. REDIRECT template:· Notes
  5. REDIRECT template:· MD&A
Auditing

Auditor's report

  1. REDIRECT template:· Financial audit
  2. REDIRECT template:· GAAS / ISA
  3. REDIRECT template:· Internal audit
  4. REDIRECT template:· Sarbanes–Oxley Act
Professional Accountants

CWA/CMA

  1. REDIRECT template:· ACCA
  2. REDIRECT template:· CA
  3. REDIRECT template:· CGA
  4. REDIRECT template:· CMA
  5. REDIRECT template:· CPA
  6. REDIRECT template:· PA

Deferred tax is an accounting concept (also known as future income taxes), meaning a future tax liability or asset, resulting from temporary differences or timing differences between the accounting value of assets and liabilities and their value for tax purposes.

Contents

Temporary differences

Temporary differences are differences between the carrying amount of an asset or liability recognized in the balance sheet and the amount attributed to that asset or liability for tax purposes (the tax base)[1].

Temporary differences may be either:

  • taxable temporary differences, which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled; or
  • deductible temporary differences, which are temporary differences that will result in deductible amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled[1].

Tax base

The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes:

  • the tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset.
  • the tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods.

Illustrated example

The basic principle of accounting for deferred tax under a temporary difference approach can be illustrated using a common example in which a company has fixed assets which qualify for tax depreciation.

The following example assumes that a company purchases an asset for $1,000 which is depreciated for accounting purposes on a straight-line basis of five years. The company claims tax depreciation of 25% per year on a declining balance basis. The applicable rate of corporate income tax is assumed to be 35%. And then subtract the net value.

Purchase Year 1 Year 2 Year 3 Year 4
Accounting value $1,000 $800 $600 $400 $200
Tax value $1,000 $750 $563 $422 $316
Taxable/(deductible) temporary difference $0 $50 $37 $(22) $(116)
Deferred tax liability/(asset) at 35% $0 $18 $13 $(8) $(41)

As the tax value, or tax base, is lower than the accounting value, or book value, in years 1 and 2, the company should recognise a deferred tax liability. This also reflects the fact that the company has claimed tax depreciation in excess of the expense for accounting depreciation recorded in its accounts, whereas in the future the company should claim less tax depreciation in total than accounting depreciation in its accounts.

In years 3 and 4, the tax value exceeds the accounting value, therefore the company should recognise a deferred tax asset (subject to it having sufficient forecast profits so that it is able to utilise future tax deductions). This reflects the fact that the company expects to be able to claim tax depreciation in the future in excess of accounting depreciation.

Timing differences

Whereas International Financial Reporting Standards and US GAAP adopt a balance sheet approach in relation to deferred tax focused on temporary differences, certain GAAPs such as UK GAAP require deferred tax to be instead recognised in respect of timing differences.

A timing difference arises when an item of income or expense is recognised for tax purposes but not accounting purposes, or vice versa, and is therefore consistent with a profit and loss approach to deferred tax.

In many cases the deferred tax outcome will be similar for a temporary difference or timing difference approach. However, differences can arise such as in relation to revaluation of fixed assets qualifying for tax depreciation, which gives rise to a deferred tax asset under a balance sheet approach, but in general should have no impact under a timing difference approach.

Justification for deferred tax accounting

Deferred tax is recognized as a result of the Matching principle. Deferred tax liabilities are provided in order that investors may understand the future tax liabilities that may arise as a result of accelerated tax relief taken to date, or income that has not yet been taxed.

Where accelerated tax relief is obtained for expenditure relative to the timing of an expense recognized in a company's profit and loss account, a deferred tax charge should be recognized in the profit and loss account for the movement in the company's deferred tax liability, which will increase the company's total tax charge.

Examples

Deferred tax liabilities

Deferred tax liabilities generally arise where tax relief is provided in advance of an accounting expense, or income is accrued but not taxed until received. Examples of such situations include:

  • a company claims tax depreciation at an accelerated rate relative to accounting depreciation
  • a company makes pension contributions for which tax relief is provided on a paid basis, whereas accounting entries are determine in accordance with actuarial valuations

Deferred tax assets

Deferred tax assets generally arise where tax relief is provided after an expense is deducted for accounting purposes.Examples of such situations include:

  • a company may accrue an accounting expense in relation to a provision such as bad debts, but tax relief may not be obtained until the provision is utilised
  • a company may incur tax losses and be able to "carry forward" losses to reduce taxable income in future years

Deferred tax in modern accounting standards

Modern accounting standards typically require that a company provides for deferred tax in accordance with either the temporary difference or timing difference approach. Where a deferred tax liability or asset is recognised, the liability or asset should reduce over time (subject to new differences arising) as the temporary or timing difference reverses.note

Under International Financial Reporting Standards, deferred tax should be accounted for using the principles in IAS 12: Income Taxes, which is similar (but not identical) to SFAS 109 under US GAAP. Both these accounting standards require a temporary difference approach.

Other accounting standards which deal with deferred tax include:

Derecognition of deferred tax assets and liabilities

Management has an obligation to accurately report the true state of the company, and to make judgements and estimations where necessary. In the context of tax assets and liabilities, there must be a reasonable likelihood that the tax difference may be realised in future years.

For example, a tax asset may appear on the company's accounts due to losses in previous years (if carry-forward of tax losses is allowed). In this case a deferred tax asset should be recognised if and only if the management considered that there will be sufficient future taxable profit to utilise the tax loss.[2] If it becomes clear that the company does not expect to make profits in future years, the value of the tax asset has been impaired: in the estimation of management, the likelihood that this tax loss can be utilised in the future has significantly fallen.

In cases where the carrying value of tax assets or liabilities has changed, the company may need to do a write down, and in certain cases involving in particular a fundamental error, a restatement of its financial results from previous years. Such write-downs may involve either significant income or expenditure being recorded in the company's profit and loss for the financial year in which the write-down takes place.

See also

Notes

  1. ^ a b IAS 12.5
  2. ^ IAS 12.34

External links


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