Deferred tax
Encyclopedia
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.
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. The applicable rate of corporate income tax is assumed to be 35%. And then subtract the net value.
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.
and US GAAP adopt a balance sheet approach in relation to deferred tax focused on temporary differences, certain GAAP
s 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.lll
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:
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. 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.
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
, resulting from temporary differences or timing differences between the accounting value of assets and liabilities and their value for tax purposes.
Temporary differences
Temporary differences are differences between the carrying amount of an asset or liability recognized in the statements of financial position and the amount attributed to that asset or liability for ta, 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.
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. 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
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's 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 StandardsInternational Financial Reporting Standards
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....
and US GAAP adopt a balance sheet approach in relation to deferred tax focused on temporary differences, certain GAAP
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s 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
Revaluation
Revaluation means a rise of a price of goods or products. This term is specially used as revaluation of a currency, where it means a rise of currency to the relation with a foreign currency in a fixed exchange rate. In floating exchange rate correct term would be appreciation. The antonym of...
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.lll
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 provisionProvisionProvision may refer to:* Provision , an industrial dance / synthpop band from Houston, Texas, USA* Provision , a term for liability in accounting* Provision , a term for a procurement condition...
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.Under International Financial Reporting Standards
International Financial Reporting Standards
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....
, 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:
- UK GAAP - Financial Reporting Standard 19: Deferred Tax (timing difference approach)
- Mexican GAAP or PCGA - Boletín D-4, el impuesto sobre la renta diferido
- Canadian GAAP - CICACanadian Institute of Chartered AccountantsThe Canadian Institute of Chartered Accountants was incorporated by a Private Act of the Canadian Parliament in 1902. This Act, now known as the Canadian Institute of Chartered Accountants Act, was last amended in 1990 to reflect the CICA’s current mandate and powers.Working in collaboration with...
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n PBU 18 (2002) Accounting for profit tax (timing difference approach)
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. 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.
External links
- Summary of International Accounting Standard 12: Income Taxes - by the International Accounting Standards BoardInternational Accounting Standards BoardThe International Accounting Standards Board is an independent, privately funded accounting standard-setter based in London, England.The IASB was founded on April 1, 2001 as the successor to the International Accounting Standards Committee...
- Summary of Financial Accounting Standard 109: Income Taxes - US Financial Accounting Standard
- Financial Reporting Standard 19: Deferred Tax - UK Financial Reporting Standard
- Deftax - Commercial Deferred Tax Software