Deferred Tax is a term used in accounting and finance to refer to the tax liabilities or assets that arise from the differences between the carrying amount of an asset or liability in the financial statements and its corresponding tax base. These differences can be temporary and will reverse over time, leading to either future taxable amounts or deductible amounts.
Explanation
Types of Deferred Tax
Deferred Tax Liabilities
Deferred Tax Liabilities (DTLs) occur when:
- Taxable Temporary Differences: The carrying amount of an asset is greater than its tax base. This leads to future taxable amounts when the asset is realized or settled.
- Example: Depreciation methods can differ between financial accounting and tax reporting, creating a temporary taxable difference.
Deferred Tax Assets
Deferred Tax Assets (DTAs) arise when:
- Deductible Temporary Differences: The carrying amount of a liability exceeds its tax base, resulting in future deductible amounts.
- Example: Provisions for bad debts might be immediately recognized for tax purposes but accounted for differently in financial statements.
Calculation
The formula to calculate deferred tax is:
Where:
- Temporary Difference: Difference between the carrying amount and the tax base.
- Tax Rate: The applicable tax rate expected at the time of reversal.
Special Considerations
- Tax Rate Changes: Any changes in the expected future tax rates must be accounted for in the deferred tax calculation.
- Reversal of Differences: The timing of the reversal of temporary differences must be estimated accurately.
- Valuation Allowance: A valuation allowance might be necessary if it is not probable that the deferred tax asset will be realized.
Examples
-
Deferred Tax Liability: A company uses accelerated depreciation for tax purposes but straight-line depreciation for accounting purposes.
$$ \text{DTL} = (\text{Carrying Amount}_{\text{book}} - \text{Carrying Amount}_{\text{tax}}) \times \text{Tax Rate} $$ -
Deferred Tax Asset: A company has recognized expenses for warranty repairs that will be deductible in the future.
$$ \text{DTA} = (\text{Liability Amount}_{\text{book}} - \text{Liability Amount}_{\text{tax}}) \times \text{Tax Rate} $$
Historical Context
Deferred tax accounting became more structured with the introduction of various accounting standards, such as IAS 12 (International Accounting Standard) issued by the International Accounting Standards Board (IASB) and ASC 740 (Accounting for Income Taxes) set by the Financial Accounting Standards Board (FASB).
Applicability
Deferred taxes are primarily applicable in:
- Corporate accounting
- Financial statement preparation
- Tax planning and compliance
Comparisons
Deferred Tax vs. Current Tax
- Deferred Tax: Relates to future tax consequences.
- Current Tax: Pertains to the tax payable or refundable for the current period.
Provisions vs. Deferred Tax
- Provisions: Immediate expenses recognized in financial statements.
- Deferred Tax: Reflects potential future tax impacts due to timing differences.
Related Terms
- Tax Base: The amount used to calculate an entity’s tax liability.
- Temporary Differences: Differences between the carrying amount of an asset or liability and its tax base.
- Valuation Allowance: A reserve against deferred tax assets if realization is uncertain.
FAQs
What causes deferred tax?
How is deferred tax reported in financial statements?
Why is it important to account for deferred tax?
References
- International Accounting Standards Board (IASB), IAS 12 – Income Taxes.
- Financial Accounting Standards Board (FASB), ASC 740 – Accounting for Income Taxes.
- KPMG – Deferred Tax Assets and Liabilities: An Update.
- Deloitte – Deferred Taxes: An Overview of Recent Changes.
Summary
Deferred tax plays a crucial role in financial accounting by capturing the tax effects of temporary differences between book accounting and tax accounting. Understanding deferred tax is essential for accurate financial reporting and compliance with accounting standards. Recognizing and measuring deferred taxes accurately entail understanding the nature of the temporary differences and the applicable tax rates. This ensures that financial statements truly reflect the future tax costs or benefits associated with current business transactions.
