Deferred Taxation

Deferred taxation is an accounting technique used to reconcile the difference between accounting tax (tax liability calculated as per financial accounting principles of entity) and regulatory tax (tax liability calculated as per regulations of tax authority) where difference is of temporary nature and will ultimately reverse over a period of time.



Tax liability is calculated on the basis entity’s profit. The Profit calculated in entity’s financial statements (accounting profit) is affected by many factors like entity’s recognition and measurement policies, estimates, expenses and incomes recognized etc.

However, tax is to be paid as per tax regulations that may dictate policies, estimates or recognition criteria that will ultimately result in carrying amounts of assets and liabilities that are not same as carrying amounts of assets and liabilities listed in entity’s financial statements. This will result in profit figure as per tax regulations to be different from the profit calculated in entity’s financial statements.

To differentiate the carrying amounts calculated under two situations we use the terms:

  1. accounting base is the value of asset or liability calculated as per entity’s accounting principles
  2. tax base is the value of asset or liability calculated as per tax rules

1 Understanding the differences – Permanent Vs Temporary

These differences may be permanent in nature or temporary

Permanent differences are such differences between accounting base and tax base that will NOT reverse over the period of time. For example a permanent difference will arise if an expense is deducted in financial statements but not allowed for deduction under tax rules. There is no accounting solutions for such differences and entity has to accept the tax rules which usually result in higher tax charge.

Temporary differences on the other hand are such differences between accounting base and tax base  that will reverse or auto-adjust over a period of time. For example difference in depreciation rate or useful life of asset. Although on year-to-year basis the difference will be there, but its just a matter of time when asset reach the same carrying amount under both accounting and tax rules. For such differences we can apply deferred taxation concept.

Example 1 – Understanding the temporary difference

Rakaposhi Plc. bought an asset for $150,000. Entity uses straight line method to depreciate the asset over 5 years time. There is no residual value. On the other hand tax authorities require entity to depreciate the asset as following:

Year 1: 80,000
Year 2: 25,000
Year 3: 20,000
Year 4: 15,000
Year 5: 10,000

Lets compare the depreciation of asset under two situations:

Year Accounting Depreciation Tax Depreciation Difference
1 30,000 80,000 50,000
2 30,000 25,000 (5,000)
3 30,000 20,000 (10,000)
4 30,000 15,000 (15,000)
5 30,000 10,000 (20,000)
Total 150,000 150,000 0

In the above table you can see that on individual year basis, accounting depreciation is different from tax depreciation. But at the end of 5 years time total is the same and even the difference reverses itself and returns zero. So this is a perfect example of temporary difference. 

1.1 Understanding the effect of temporary difference

In the example above we understood how temporary difference works and auto-adjust itself over a period of time. As mentioned earlier, if we look on individual years, they are different and this difference will affect the way carrying amount of asset is calculated for accounting purposes and for tax purposes.

Continuing the same example as discussed above, we can easily calculate the accounting base and tax base for the asset as following:

Year Accounting depreciation Accounting
base
Tax
depreciation
Tax
base
150000 150000
1 30000 120000 80000 70000
2 30000 90000 25000 45000
3 30000 60000 20000 25000
4 30000 30000 15000 10000
5 30000 0 10000 0

If we compare accounting base and tax base with each year, the accounting base and tax base will give cumulative effect of depreciation difference instead of simple year-to-year difference that we saw in Example 1:

Year Accounting base Tax
base
Cumulative
Difference
150000 150000
1 120000 70000 50,000
2 90000 45000 45,000
3 60000 25000 35,000
4 30000 10000 20,000
5 0 0 0

To summarize the above discussion just remember two things:

  1. Comparing the accounting base and tax base will give you cumulative difference; whereas
  2. Comparing the “differentiating item” e.g. depreciation expense will most probably give you periodic difference.

The so-called “periodic difference” and “cumulative difference” are just two concepts made up here to make students better understand the calculations involved in deferred taxation. So just remember it for now as we later see their importance in calculations.

To emphasize again, both permanent and temporary differences can result in different tax base and accounting base, however, its only temporary difference that we can reconcile using deferred taxation approach. Therefore, from this point forward, whenever the word difference is referred it actually means temporary difference.

2 Deferred tax liability and deferred tax asset

Put it in simple words:

  1. Deferred tax liability arises if accounting base is greater than tax base i.e. accounting base > tax base
  2. Deferred tax asset arises if tax base is greater than accounting base i.e. tax base > accounting base

Lets understand why without getting into technicalities.

Word “deferred” delayed or postponed for a later date.

So deferred tax liability simply means a liability recognition of which has been delayed. Or technically, an obligation that entity will pay in the future and been delayed for the time being.

Similarly deferred tax asset simply means an asset recognition of which has been delayed. Or technically entity will recover it in the future and been delayed for the time being.

2.1 Deferred tax liability – Concept, Calculation and Accounting

Remember deferred tax liability arises when accounting base > tax base. This must have happened if entity has charged lesser expense to profits under its accounting than what should have been as per tax authorities.

For example entity bought an asset for $5,000. Asset has 5 years life and entity is charging depreciation on straight line basis. This gives first year’s depreciation $1,000 (5,000 / 5) and carrying amount to be $4,000 (5,000 – 1,000)

Tax authorities however, require first year’s depreciation to be 1,500. This will give the carrying amount to be 3,500 (5,000 – 1,500)

Now two things to pay attention to:

  1. accounting base (4,000) is greater than tax base (3,500). Mentioned it to for a reminder.
  2. charging lesser depreciation in accounting (1,000) causing profits to increase and charging higher depreciation as per tax rules (1,500) causing profits to decrease.

Now that entity has higher profits under its accounting which translates to higher tax liability, its just that profit calculated as per tax rules is lesser and thus actual tax paid will be lesser than liability calculated as per entity’s accounting. In short, entity’s books calculated higher tax liability but as actual payment is lesser, the remainder of the tax liability is deferred thus creating deferred tax liability.

The amount of tax that is delayed can be calculated easily by multiplying temporary difference with tax rate.

Example – Calculating deferred tax liability

Entity bought an asset for 5,000 and estimated the useful life to be 5 years and depreciate the asset on straight-line basis.

If the tax rate is 20% and tax rules require first year’s depreciation to be 1,500, calculate the deferred tax liability amount to be recognized.

Solution:

Accounting depreciation = 5,000 / 5 1,000
Tax depreciation = – Given – 1,500
Reported in Income statement – Increase 500
Accounting base = 5,000 – 1,000 4,000
Tax base = 5,000 – 1,500 3,500
Reported in Balance sheet – Closing balance = 500
Calculating temporary difference
Students often get confuse right at this step i.e. determining temporary difference as there are two things that are giving difference:

  1. depreciation charge (which will give temporary difference of particular period only) under accounting books and tax books
  2. carrying amount of asset or liability (which will give cumulative temporary difference of this period + previous periods) i.e. accounting base and tax base

So which one should be used to calculate deferred tax amount? Both can be used but each of them will render different things and should be treated accordingly.

  1. comparing “individual period” related difference i.e. depreciation charge will give increase or decrease in deferred tax amount
  2. comparing accounting base and tax base will give closing balance of deferred tax amount.

Example – Calculating deferred tax liability

Entity bought an asset for 5,000 and estimated the useful life to be 5 years and depreciate the asset on straight-line basis.

If the tax rate is 20% and tax rules require depreciation to be charged as following:

Year 1 1,500
Year 2 1,200
Year 3 1,000
Year 4 800
Year 5 500

What is the nature of deferred tax? Also calculate the deferred tax amount to be recognized for five years.

Solution:

If it is deferred tax liability or asset can be determined by looking at accounting base and tax base at the end of year 1.

Year 1
Accounting depreciation = 5,000 / 5 1,000
Tax depreciation = – Given – 1,500
Difference 500
Reported in income statement – Increase = 500 x 0.2 100
Accounting base = 5,000 – 1,000 4,000
Tax base = 5,000 – 1,500 3,500
Difference 500
Reported in balance sheet – Closing balance = 500 x 0.2 100
Accounting base > Tax base = Deferred tax liability
Year 2
Accounting depreciation = 5,000 / 5 1,000
Tax depreciation = – Given – 1,200
Difference 200
Reported in income statement – Increase = 200 x 0.2 40
Accounting base = 5,000 – 2,000 3,000
Tax base = 5,000 – 2,700 2,300
Difference 700
Reported in balance sheet – Closing balance = 700 x 0.2 140
Year 3
Accounting depreciation = 5,000 / 5 1,000
Tax depreciation = – Given – 1,000
Difference 0
Reported in income statement – Nill = 0 x 0.2 0
Accounting base = 5,000 – 3,000 2,000
Tax base = 5,000 – 3,700 1,300
Difference 700
Reported in balance sheet – Closing balance = 700 x 0.2 140
Year 4
Accounting depreciation = 5,000 / 5 1,000
Tax depreciation = – Given – 800
Difference (200)
Reported in income statement – Decrease = (200) x 0.2 (40)
Accounting base = 5,000 – 4,000 1,000
Tax base = 5,000 – 4,500 500
Difference 500
Reported in balance sheet – Closing balance = 500 x 0.2 100
Year 5
Accounting depreciation = 5,000 / 5 1,000
Tax depreciation = – Given – 500
Difference (500)
Reported in income statement – Decrease = (500) x 0.2 (100)
Accounting base = 5,000 – 5,000 0
Tax base = 5,000 – 5,000 0
Difference 0
Reported in balance sheet – Closing balance = 0 x 0.2 0

Following is the T-account of deferred tax liability

Deferred tax liability a/c
Year 1
Profit and loss a/c 100
Closing balance 100
100 100
Year 2
Opening balance 100
Profit and loss a/c 40
Closing balance 140
140 140
Year 3
Opening balance 140
Closing balance 140 140
140 140
Year 4
Opening balance 140
Profit and loss a/c 40
Closing balance 100
140 140
Year 5
Opening balance 100
Profit and loss a/c 100
100 100

2.2 Deferred tax asset – Concept, Calculation and Accounting

Again, deferred tax asset arises when tax base > accounting base. This will happen if expense charged as per entity’s accounting is higher than what should have been as per tax regulations.

Suppose entity bought an asset for $5,000 that has five years life and depreciates on straight line basis. Depreciation for the first year will be $1,000. (5,000 /5). This renders asset’s carrying amount to be $4,000.

If tax rules require first year’s depreciation to be $800. This means asset’s carrying amount should be 4,200 (5,000 – 800).

Again, two things to pay attention to:

  1. Tax base (4,200) > accounting base (4,000)
  2. Depreciation expense charged as per entity’s accounting is more than tax depreciation charge. This will result in lower profits under accounting and higher profits under tax rules.

Now that entity’s accounting has rendered lower profits, entity is supposed to recognize lower tax liability. However, tax profits are greater and will result in higher tax amount and thus actual tax payment will be higher than the liability calculated as per entity’s accounting. In short, entity has paid higher tax than the amount calculated as per entity’s books and the amount paid above is just like prepaid expense thus creating deferred tax asset.

Example – Calculating deferred tax asset

Kitchen Nightmare bought a refrigerating unit for 10,000. Entity has decided to depreciate the asset at 20% every year. According to tax rules the asset needs depreciation as following:

Year 1 800
Year 2 1,700
Year 3 2,000
Year 4 2,200
Year 5 3,300

If tax rate is 30% give the deferred tax account

Solution:

In year 1 the accounting depreciation charge is:

10,000 x 0.2 = 2,000

The tax depreciation however is 1,000. This will result in Tax base (9,000 = 10,000 – 1,000) to be greater than accounting base (8,000 = 10,000 – 2,000) therefore, entity will recognize deferred tax asset in year 1 which will reverse over the useful life of the asset.

Deferred tax asset a/c
Year 1
Profit and loss a/c
[2,000 – 800 = 1,200 x 0.3]
360
Closing balance
[8,000 – 9,200 = 1,200 x 0.3]
360
360 360
Year 2
Opening balance 360
Profit and loss a/c
[2,000 – 1,700 = 300 x 0.3]
90
Closing balance
[6,000 – 7500 = 1,500 x 0.3]
450
450 450
Year 3
Opening balance 450
Profit and loss a/c
[2,000 – 2,000 = 0 x 0.3]
0
Closing balance
[4,000 – 5,500 = 1,500 x 0.3]
450
450 450
Year 4
Opening balance 450
Profit and loss a/c
[2,000 – 2,200 = (200) x 0.3
60
Closing balance
[2,000 – 3,300 = 1300 x 0.3]
390
450 450
Year 5
Opening balance 390
Profit and loss a/c
[2,000 – 3,300 = (1,300) x 0.3
390
390 390