What is Deferred Tax?

Concept of Deferred Tax

This is very common in corporate area that the tax calculation of an accountant differs with the tax calculate by the tax authorities. Sometimes a company may pay more taxes than the authorities calculation and a situation of deferred tax assets arise. On the other hand, sometimes the tax calculation of an accountant will be lower than the calculation of authorities and deferred tax liabilities arisen. This is all about the situation of raising differed tax liabilities and deferred tax assets.

From this post, we can understand the situation when the deferred tax assets and the deferred tax liabilities raised.

Deferred Tax is a basis of allocating tax charges to particular accounting periods. It is the application of accrual concept that may eliminate a mismatch between the accounting profit and taxable profit of the business.

Hence, we may say, Deferred tax is the estimated future tax consequences of transactions and events recognized in the financial statements of the company of its current and previous periods. Deferred tax arises due to the temporary differences in accounting profit and taxable profit of the company.

Types of Differences

Though Deferred tax arises due to temporary differences, we should have clear understand regarding permanent differences also.

However, there is two types of differences explained in the deferred tax issue. such as :

  • Permanent Differences
  • Temporary Differences

Permanent Differences:

Permanent differences is the differences between tax expenses and tax payable because of an item which can not be reversed over the time. Permanent differences will cause a difference between the statutory tax rate and effective tax rate. This type of difference never reverse and may affect only on the current accounting period.

As it has no impact on future accounting periods they don’t have any impact on deferred tax liability. For example, an expense which is not admissible in the eye of tax authority but included in the financial statement will not create deferred tax issue because of the expenses is always inadmissible and would never reverse. Hence, Permanent difference will not impact deferred tax.

However, some expenses which may create temporary differences are enumerated as follows:

  • Capital Expenditures
  • Personal Expenditures
  • Tax exempted income
  • Income Tax
  • Inadmissible expenses etc.

Temporary Differences:

Deferred Tax arises from the temporary differences. Temporary differences occur when a business has an asset with a liability value that does not match with the current taxable value of the asset. Temporary differences may impact on financial statement because of income and expenses appear within one accounting period, but the tax payable in a different accounting period. A taxable difference could be taxable or deductible.

Some example of Temporary differences are as follows:

  • Difference between Accounting Profit and Taxable Profit create Temporary differences
  • When Advance is received from the customer, the company treated it as advance and recognize as income when the goods or services are delivered. But Tax authority consider it as income when the money is received.

Deferred Tax Liability and Deferred Tax Assets

Deferred Tax Liability:

Deferred Tax Liabilities are the income tax payable in future periods in respect of taxable temporary differences. This tax liability occurs from the difference of Accounting Profit and Taxable Profit. When the accounting profit is lower than the taxable profit, the deferred tax liability occurs and an entity to be placed on the balance sheet in the form of a liability.

Examples of Deferred Tax Liabilities:

XYZ Ltd owns a machine which is eligible to apply Accelerated Depreciation. The Company intends to apply accelerated depreciation method that allows higher depreciation deductions earlier in ownership of the asset and lower depreciation charge on later period.

On the other hand, the tax authority may use Straight Line Depreciation method. In Straight Line Depreciation Method the depreciation is spread evenly over the useful life of the asset.

Since, XYZ Ltd using Accelerated Depreciation, the accounting profit will be lower than taxable profit and a deferred tax liability will be occurred.

Deferred Tax Asset:

Deferred Tax Asset is occurred when a company pay overtax for a particular tax period. If taxes are overpaid or paid in advance, then the amount of over payment can be considered as asset. This tax also occur due losses that are carried over to a new accounting period from a particular accounting period and can then be claimed in the new period as an asset.