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Concept of Deferred Tax and Its Presentation in Financial Statements

Deferred Tax: Concept and Presentation in Financial Statements

Tax expense recorded in financial statements does not always equal the tax liability for the period under consideration. This disparity may be perplexing if a company makes profits but its tax liability for the period does not match the tax expense shown in its accounting statements. Deferred tax is the answer.

The concept of deferred tax refers to the tax impact on transactions in which there is a difference between the book value and tax base of the assets or liabilities. According to IAS 12, companies should usually recognize tax liabilities from taxable temporary differences and tax assets from deductible temporary differences.

Deferred tax is essential to understand the reasons why tax expense, tax payable, and the figures shown on the balance sheet do not match.

Also Read: Depreciation as per Section 32 of the Income Tax Act

What Is Deferred Tax?

Deferred tax refers to the future tax consequences of the difference between accounting and tax treatment.

A firm prepares its accounts according to the relevant accounting frameworks. Simultaneously, taxable income is computed using tax laws. Since the two differ from each other at times, an income or expense is recorded at different times under both accounting and tax.

This difference will reverse itself in future periods, and this future tax consequence is referred to as deferred tax.

In other words:

Deferred Tax = Temporary difference × Applicable tax rate

It is important to consider the accounting framework and tax laws before applying the formula.

Deferred Tax Asset vs Deferred Tax Liability

Basis	Deferred Tax Asset	Deferred Tax Liability
Meaning	Future tax benefit	Future tax obligation
Common cause	Deductible temporary differences	Taxable temporary differences
Effect	May reduce future tax payments	May increase future tax payments
Examples	Certain provisions, unused tax losses	Different depreciation treatment
Balance sheet effect	Asset	Liability

According to IAS 12, deferred tax assets should be recognized where there is a deductible temporary difference, unused tax loss carryforwards, and unused tax credit carryforwards.

Also Read: Concept of Deferred Tax and Its Presentation in Financial Statements

What Is a Deferred Tax Asset?

A Deferred Tax Asset is a future tax benefit that could arise from deductible temporary differences, unrecognised tax losses, and unrecognised tax credits.

Let's say that an expense item is recorded in the books of the firm for the current period but can only be deducted for tax purposes once certain criteria are satisfied in a future period. The expense for accounting and the tax deduction happen in different periods of time.

The difference can result in deferred tax assets.

It should be noted that a DTA does not get automatically recognised in all circumstances. According to IAS 12, recognition largely depends on the probability of availability of sufficient taxable profit against which the deductible temporary difference or unrecognised tax losses can be set off.

What Is a Deferred Tax Liability?

Deferred Tax Liability refers to the future tax effects of taxable temporary differences.

This can be illustrated using the concept of depreciation.

Depreciation in the books of accounts could be different from that which is deductible for tax. In case the tax deduction is greater in the early years, the business could end up paying less tax during the current year. This would lead to the creation of a deferred tax liability due to future payments that might be made in respect of this difference.

In case there is an asset having a carrying value of ₹10 lacs in the books of account while having a tax base of ₹7 lacs, this difference of ₹3 lacs could lead to the creation of a taxable temporary difference.

Temporary Differences and Permanent Differences

It is important to distinguish between temporary and permanent differences.

Temporary Differences

Temporary differences occur where there is a discrepancy between the carrying amount of an asset or liability and its tax base. Temporary differences are expected to be reversed in future periods. The approach of using differences in carrying amounts and tax bases is followed under IAS 12 for recognition of deferred tax.

Examples include:

Depreciation method/rate differences
Provisions made for accounting purposes before tax-deductible
Timing differences relating to revenue
Differences related to revaluation
Differences relating to leases

Permanent Differences

Differences that are permanent do not revert back to accounting profit in future periods.

As a case in point, a disallowed cost in tax computation that may reduce accounting profit will not reduce taxable profit at any point in time. Therefore, a permanent difference cannot result in a deferred tax asset or liability.

The significance of permanent differences lies in the fact that not all differences lead to deferred tax.

How Is Deferred Tax Calculated?

The computation begins by determining the temporary difference.

Step 1: Determine the Carrying Amount

The carrying amount is the amount at which the asset or liability is recognised in the accounting records.

Step 2: Determine the Tax Base

Tax base refers to the amount attributed to the asset or liability for tax purposes.

Step 3: Determine the Temporary Difference

Determine the temporary difference by comparing the carrying amount and tax base.

Step 4: Utilise the Appropriate Tax Rate

Temporary differences are measured at the tax rates expected to apply in the period the temporary difference is expected to reverse. The tax rates or laws must be enacted or substantially enacted by the reporting date. Deferred tax assets and liabilities are not discounted in accordance with IAS 12.

Example :

Assumption:

Book value of the machine = ₹10,00,000
Tax base = ₹7,00,000
Temporary Difference = ₹3,00,000
Applicable tax rate = 25%

Then, Deferred Tax Liability would be:

₹3,00,000 x 25% = ₹75,000

It is a simple illustration. There may be cases where more

Presentation of Deferred Tax in Financial Statements

The treatment of deferred taxes is a key issue in the preparation of accounting statements.

According to IAS 12, deferred tax assets and liabilities should be shown in the statement of financial position as non-current assets and liabilities, respectively. Current tax and deferred tax are recognized in the profit or loss statement unless the underlying item of income or expense is not recognized there.

Balance Sheet

Deferred tax assets and deferred tax liabilities are presented in the balance sheet.

It can present either:

Deferred tax asset
Deferred tax liability
Changes relating to the above during the reporting period

Whether deferred tax assets and liabilities may be offset will depend on the accounting rules prevailing. Companies should not merely subtract the amounts without considering the rules.

Profit and Loss Statement

Deferred tax may influence tax expense shown in the profit and loss statement.

For instance, an increase in the deferred tax liability will result in higher tax expense, while a recognised deferred tax asset may lower tax expense, depending on the nature of the transaction and its accounting treatment.

Other Comprehensive Income and Shareholders' Equity

If the transaction is included in other comprehensive income or is directly included in the shareholders' equity, then its tax consequence should be recognized accordingly.

Deferred Tax and Financial Statement Analysis

Deferred tax is more than just an accounting entry. It may also have an effect on the way users of financial statements view the same.

Where there is a deferred tax liability, it increases the reported liabilities. The deferred tax asset increases the reported assets where applicable.

Users of financial statements are expected to take into account the following when evaluating the deferred tax items:

Profitability
Assets and liabilities
Tax obligations in the future
Quality of income
Financial position
Tax risks

A significant deferred tax asset should be evaluated for the potential generation of sufficient income to enjoy the tax benefit.

Why Is Deferred Tax Important?

Deferred tax ensures that the future tax impacts of past transactions are properly accounted for within the financial statements.

Significance includes:

Improvement in financial reporting: It aids in reconciling financial results to their future tax impacts.

Transparency: It allows users to see the reasons behind differences between accounting tax expenses and current tax liability.
Accurate financial position: Deferred tax is shown within the balance sheet.
Decision-making: Management and investors can consider future tax impacts of decisions.
Better compliance: Appropriate recognition and disclosure help companies comply with relevant accounting standards.

It is important to keep books and relevant records of transactions in an organization, as accounting information is the basis of financial reporting. For more information, refer to Swipe’s guide on Book of Accounts Rules – Section 44AA of the Income Tax Act.

Deferred Tax vs Current Tax

Feature	Current Tax	Deferred Tax
Timing	Relates to current or prior periods	Relates to future tax consequences
Main basis	Current taxable income	Temporary differences
Balance sheet impact	Tax payable or recoverable	DTA or DTL
Purpose	Shows current tax obligation or recovery	Shows future tax effects

The tax is calculated based on the anticipated payment to or collection from the tax department. The deferred tax is concerned with the tax implications of the temporary difference in the future.

In addition, the companies can refer Depreciation as per Section 32 of the Income Tax Act, since differences in depreciation treatment are one of the areas where there could be discrepancies between tax and accounting figures.

Key Practical Points to Consider

When dealing with deferred tax issues, companies need to:

Recognise all relevant temporary differences.
Make a proper determination of the tax base.
Differentiate between temporary differences and permanent differences.
Use the correct enacted or substantively enacted tax rate.
Analyse deferred tax assets at every reporting date.
Consider whether there are any future taxable profits to utilise the deferred tax assets.
Examine whether offsetting criteria are met.
Account for deferred tax in accordance with the relevant accounting standards.

For companies that are currently developing their accounting system, it is equally important to keep proper accounting records. An accurate profit and loss account will help managers see the connection between accounting profit and tax amounts.

Conclusion

Deferred taxes serve as a means to explain one significant difference between accounting and taxation. They are primarily created because of the differing treatment of income, expenses, assets, and liabilities under accounting and tax laws.

Deferred taxes are categorized into two primary types: deferred tax assets and deferred tax liabilities. Temporary differences constitute the basis of deferred taxes, while permanent differences usually do not create deferred taxes.

In order to prepare accurate financial statements, companies have to analyze temporary differences, determine the tax base, calculate the tax rate, and evaluate the recognition criteria for deferred tax assets and liabilities.

Learning about deferred taxes can initially appear complicated; however, the main concept is quite simple – the treatment of something today will affect your tax situation in the future. Companies should consider the above-mentioned balances thoroughly and seek the assistance of a professional accountant if required.

FAQs

What is deferred tax?

Deferred tax is an accounting concept that covers future tax effects that arise due to temporary differences between book values and tax bases of assets and liabilities.

What is a deferred tax asset?

A deferred tax asset is an accounting concept that covers future tax advantages that result from deductible temporary differences, carryforward tax losses, or tax credits, among others.

What is a deferred tax liability?

A deferred tax liability is an accounting concept that relates to future tax effects due to taxable temporary differences.

How does deferred tax occur?

Deferred tax is normally triggered by discrepancies in depreciation, revenue recognition, provisioning, valuation, and other similar transactions.

Is deferred tax the same as current tax?

No. Current tax is the tax payable or receivable for the period or periods. Deferred tax is the tax effects of the differences THAT will reverse in the future.

Where is deferred tax disclosed in financial statements?

According to IAS 12, deferred tax assets and liabilities should be presented as non-current items in the statement of financial position. The tax income or expense arising from these differences should generally be presented in the profit or loss unless otherwise stated in another accounting policy.

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