What is Deferred Tax?

Deferred tax is an estimated future tax which is made while preparing accounts. It is estimated as a result of past and present transactions in the financial statements. It is not the actual tax which needs to be paid or refundable from the revenue authority, it is an accounting entry. It exists because of the difference between accounting profits and taxable profits.

Companies maintain books as per company law but pay tax according to income tax law. Companies calculate the profit or loss as per accounting rule as well as tax laws, because of the different application of rules differences arise.

These temporary differences are accounted for, recognized and carried forward in the books of accounts and accordingly deferred tax assets and deferred tax liability are created.

Deferred Tax Assets and Deferred Tax Liability

Deferred tax is an item of the balance sheet it is created when tax paid is more than tax considered on the income statement. It results from over payment and advance payment or advance payment from taxes. Deferred tax assets are recorded on the assets side of the balance sheet.

Deferred tax results in the reduction of future tax payment thus it is beneficial. it arises when the profit as per tax laws is more than the profit as per books of accounts.

Deferred tax liability is created when tax paid is less than tax considered on the income statement. It is recorded on the liability side of the balance sheet. It results in the increment of future tax payment thus it is a burden. It arises when the profit as per tax laws is less than profits as per books of accounts.

How Deferred Tax Assets Arises?

Carryover of losses is the common example of deferred tax assets. We know the loss lowers the income of the company hence when a businesses incur a loss in a financial year then they show it in order to lower their taxable income. In this manner we can say that loss is an asset because it lowers the taxable income which is beneficial for the company.

Another case where deferred tax assets arise is that when there is difference between accounting rules and tax rules.

When expenses are recognized in the income statement then the deferred tax asset arises because they are recognized before that should be required by the tax authorities. It arises because of overpayment or prepayment of taxes which will benefit in future. These overpayments arise when there is any change in the tax rules or code.

Consideration for Deferred Tax Asset

For most companies, deferred tax assets can be carried forward but it cannot be carried back. It should be known how changes in tax rate will affect the value of deferred tax assets. When the tax rate is rising then it is beneficial for the company because the asset value goes up. But if the tax rate falls then the asset value also declines, this is nor favorable for the company.

How Deferred Tax Liability Tax Arises?

It is the due tax which has not been paid for the current accounting period. It is the difference of timing of the tax accrued and when it is paid. It is an obligation for the company to pay taxes in near future. Sometimes accounting rules and tax laws differ, company income before the tax can be greater than actual tax on tax return, it will give rise to deferred tax liability. It represents that the company needs to pay the future tax to the tax authorities. In other words we can say that the deferred tax liability is the amount which has not been paid and will be paid in the future date. It doesn’t mean that any individual has not paid the obligations, but it has been paid on different dates.

For example for an accounting year a company knows it has to pay the corporate tax on income for that accounting year but the tax will not be paid until the next accounting year in order to rectify the cash timing differences and tax deferred liability is recorded.

Calculation of Deferred Tax Liability

To understand how deferred tax liability is calculated let us understand with an example of a company which has sold a Television worth $1000 with a tax rate of 20%. But customers will pay this amount in two instalments of $500 each.

For accounting and financial purpose company will record sale of $1000, but for the tax payment it will record as only $500.This will result in deferred tax liability of $500* 20%= $100.

Various Sources of Deferred Tax Liability

Most common source of the deferred tax liability is the difference of the treatment of depreciation tax by the accounting rules and the tax laws. For the financial purpose mainly the straight line method is used to calculate the depreciation, but tax regulations suggest using the accelerated depreciation method.

Because the depreciation calculated from the straight line method is lower than the depreciation produced by the accelerated depreciation method a company’s income is higher than its taxable income.

Continuation of depreciation of asset the difference between straight line depreciation and the accelerated depreciation goes down.

Another source is the instalment sale. According to the accounting rule the company records full income from the instalment sale but according to the tax law the company is required to recognize the income when the instalment payment is received. It creates the difference between the company income and taxable income; hence the deferred tax liability arises.

Context and Applications 

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for

• B.Sc.
• M.Sc.
• B.Com