Taxation is an integral aspect of any business’s financial operations. It plays a vital role in determining profitability and compliance. However, the interaction between accounting standards and tax regulations often gives rise to a concept known as deferred tax. In this article, we’ll discuss deferred tax in detail, its types, examples, how to calculate it, whether the tax liability is good and more.
Deferred Tax Meaning
Deferred tax is an accounting treatment of taxes paid or owed in a different period compared to the time transaction occurred. This is used while preparing a company’s financial statements as per the Generally Accepted Accounting Principles (GAAP). These temporary tax differences can occur due to factors such as depreciation methods, revenue recognition practices, accrued expenses, and unrealised gains or losses.
The deferred tax on the balance sheet is treated as an asset or liability.
Types of Deferred Tax
There are two main types of deferred tax:
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Deferred Tax Liabilities
Deferred tax liabilities arise when the taxable income reported in the financial statements is lower than the taxable income calculated for tax purposes. This means that a company has deferred paying taxes on certain income, and it will be liable to pay those taxes in the future when the temporary differences reverse.
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Deferred Tax Assets
Deferred tax assets arise when the taxable income reported in the financial statements is higher than the taxable income calculated for tax purposes. This means that a company has paid more in taxes than required, and it is entitled to receive tax benefits in the future when the temporary differences reverse.
Example of the Deferred Tax
Let’s take an example to understand the deferred tax better. Assume there is a small retail business that records revenue when cash is received and expenses when cash is paid. However, during financial reporting, they follow the accrual basis of accounting, i.e., recognising revenue when it is earned and expenses when they are incurred.
At the end of the year, the retail business provided services worth Rs. 10,000 to customers but has only received Rs. 8,000 in cash payments. According to the cash basis of accounting, they would report Rs. 8,000 as taxable income. However, under the accrual basis of accounting, they would recognise the full Rs. 10,000 as revenue.
In this case, there is a temporary difference of Rs. 2,000 between the taxable income reported for tax purposes and the revenue recognised in the financial statements.
Since the taxable income is lower than the revenue, the business has deferred paying taxes on the Rs. 2,000 difference. This Rs. 2,000 is recognised as a deferred tax liability because it represents the taxes that the business will have to pay in the future when the temporary difference reverses and the full Rs. 10,000 is recognised as taxable income for tax purposes.
The deferred tax liability is recorded on the business’s balance sheet as a long-term liability until it is settled in the future. It serves as a reminder that the business will have a future tax obligation on the amount of revenue that was recognised in the financial statements but not yet taxed.
How is Deferred Tax Calculated?
Firstly, for deferred tax calculation, you need to identify temporary differences between financial reporting and tax accounting. Temporary differences can arise from factors like different depreciation methods or revenue recognition practices. Once identified, you determine if the temporary differences are taxable (resulting in future tax payments) or deductible (resulting in future tax savings).
To calculate the deferred tax amount, multiply the temporary difference by the applicable tax rate. The tax rate used should reflect the tax laws and rates expected to be in effect when the temporary difference reverses. The resulting figure represents the deferred tax liability or asset. Deferred tax liabilities are recorded when the taxable income will be higher in the future, while deferred tax assets are recognised when the taxable income is lower. These calculations are essential for accurate financial reporting and understanding the future tax consequences of temporary differences.
Instances in which Deferred Tax is Recorded
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Depreciation differences:
When a company uses various depreciation methods for financial reporting and tax purposes, temporary differences arise. For example, suppose a company uses accelerated depreciation for tax purposes and straight-line depreciation for financial reporting. In that case, there will be a temporary difference between the higher depreciation expense claimed for tax purposes and the lower expense recognised in the financial statements. This difference results in deferred tax liability because the company will eventually have to pay taxes on the higher depreciation deductions claimed in prior periods.
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Revenue recognition timing:
Differences in revenue recognition timing can also lead to deferred tax. For example, a company may identify revenue for financial reporting purposes when it is earned, even if payment is received later. However, for tax purposes, revenue may be recognised when cash is received. This can create a temporary difference where taxable income is lower in the current period. Ultimately, this results in a deferred tax liability as the company will pay taxes on the revenue recognised for financial reporting purposes in future periods when the cash is received.
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Unrealised gains or losses:
Unrealised gains or losses on certain investments or financial instruments can give rise to deferred tax. For instance, if a company holds an investment in stocks or bonds that have increased in value but has not sold them, it may recognise these unrealised gains in its financial statements. However, these gains are not yet taxable as they are considered unrealised. Consequently, a deferred tax liability is recorded to account for the taxes that will be payable when the gains are realised and included in taxable income.
Is Deferred Tax Liability Good or Bad?
The classification of deferred tax liability as good or bad depends on the specific context and perspective. Here are two different views to consider:
Financial reporting compliance
From the view of financial reporting compliance, deferred tax liabilities are a natural and essential part of accounting for temporary differences between financial reporting and tax accounting. They represent future tax obligations that will be settled when the temporary differences reverse. In this scenario, deferred tax liabilities are not naturally good or bad; they are simply a reflection of the timing difference between recognising income or expenses for financial reporting purposes and tax purposes.
Companies are required to accurately recognise and disclose deferred tax liabilities to comply with accounting standards and provide transparent financial statements.
Financial performance and cash flow
When you look into the financial performance and cash flow, deferred tax liabilities can have implications. If a company has significant deferred tax liabilities, it suggests that they have deferred paying taxes on certain income or deductions, which resulted in lower tax payments in the current period. This can be considered a benefit in the short term, as it provides a cash flow advantage and can contribute to higher reported net income.
However, it’s important to note that deferred tax liabilities represent future tax obligations, and when these liabilities reverse, the company will have to pay taxes, which may impact cash flow and reduce reported net income in the future.
Benefits of Deferred Tax
- There can be an improved accuracy of financial reporting.
- It enhances tax planning and cash flow management.
- It can smoothen the tax burden over multiple periods.
- It supports business investments and expansion.
- It can potentially reduce the effective tax rate.
Know more about “The Ultimate Guide to Income Tax”
FAQs
What is deferred tax?
Deferred tax means the taxes that will be paid or owed in the future due to the current temporary differences between financial accounting and tax accounting.
What is the difference between deferred tax liability and deferred tax asset?
Deferred tax liability is when the taxable income is less in the financial statements compared to tax statements. On the other hand, deferred tax assets are when taxable income is higher on the financial statements compared to tax statements. A deferred tax asset is considered a future tax benefit, while a deferred tax liability is considered a future tax obligation.
How are deferred tax liabilities reported in financial statements?
On the company’s balance sheets, the deferred tax liabilities are specified as long-term liabilities. Usually, they are mentioned in the notes of a financial statement with detailed information on their amount, time period, etc.
