There are two different financial reports which an organization prepares every fiscal year – an income statement and a tax statement. The motive behind the creation of two different financial reports was a difference in guidelines behind the preparation of a company’s income statement and tax statement. Therefore, this disparity creates the scope for deferred tax. It is an important accounting measure.
What is Deferred Tax?
It is brought into accounts to make a clear picture of current tax and future tax. Current tax is the amount of income tax to be payable (recoverable) in respect of the taxable income (tax loss) for a period. Furthermore, a deferred tax of any type appears in the balance sheet of an organization.
Timing Differences
Because of certain items which are specifically allowed or disallowed each year for tax purposes, there occurs a difference between the book profit and taxable profit. The difference between the book and the taxable income or expense refers to the timing difference. Deferred tax is the tax effect of timing differences. It can be either of the following:
- Temporary differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods.
- Permanent differences are the differences between taxable income and accounting income for a period that originate in one period and do not reverse subsequently.”
Types of Deferred Tax
- Deferred Tax Liability (DTL): DTL generally arises where tax relief is provided in advance of an accounting expense/unpaid liabilities, or income is accrued but not taxed until received. In simple words, the deferred tax liability arises when there is a timing difference between when a tax liability accrues and when a company is liable to pay it.
- Deferred Tax Assets (DTA): When there is a difference between the income statement of an organization and its corresponding tax statement that means the company pays its tax liability for another period in advance or is able to reduce its tax liability for a subsequent period in a particular, financial year. Then the difference amount is recorded as DTA.
The effects of deferred taxes i.e. DTA and DTL in the financial statements are as under:
| Sl.No | Profit Status | Current Treatment | Future Treatment | Effect |
| 1 | Book profit higher than the Taxable profit | Pay less tax now | Pay more tax in future | Creates Deferred Tax Liability (DTL) |
| 2 | Book profit is less than the Taxable profit | Pay more tax now | Pay less tax in future | Creates Deferred Tax Asset (DTA) |
Scenarios where Deferred Tax is Recorded
Unrealized revenues and expenses
As per the Income Tax Act, tax cannot be levied on revenues which have yet not been realised by companies. Thus, if there are unrealised receivables from debtors, then although as per accounting laws it shall be recorded in the income statement; it is not considered for taxation. This disparity in treatment of revenues creates a deferred tax liability because companies are have to pay tax on a later date when they realise such receivables.
Similarly, when there are expenses which a company has recorded in its books but has not yet incurred is not considered for tax calculations. Thereby, such company’s gross profit in its books is lower than what appears in its tax statement. Consequently, an organisation ends up paying advance tax for a higher profit in tax statements. Hence, that creates a deferred tax asset.
The difference in the depreciation calculation method
A deferred tax is created when there is a difference between the approach in which a company calculates depreciation on its assets and the method of depreciation calculation as prescribed by the IT Department.
For example, Company X calculates depreciation in the straight-line method; whereas the Income Tax Department follows the Written Down Value depreciation method. This company has a computer worth INR 1,00,000 with an estimated lifetime of 5 years and it expects no salvage value for the same. Hence, depreciation as per their calculation shall be INR 20,000. Now, as per the Income Tax Department depreciation is INR 25,000. As seen, IT department considers higher depreciation, which implies a lower tax liability for the company for that particular financial year. However, company X will adjust depreciation in the subsequent years so that it eliminates such inconsistency between the two depreciation figures by the end of the machinery’s lifetime. Hence, it poses a future financial obligation accruing in that particular year, thus creating a deferred tax liability.
Difference in Depreciation Percentage
If there is a difference in the percentage of depreciation calculation that takes place by an organisation on its assets and considered by the IT department, then a deferred tax can be created.
For instance, company B has assets worth INR 80,000 on which it calculates 10% depreciation whereas as per the IT department, depreciation shall be calculated at the rate of 15%. As per the IT Department, depreciation is INR 12,000, while as per the company’s calculation depreciation is INR 8,000. This temporary difference of INR 4,000 will create a deferred tax asset as the company is paying an additional tax of INR 1000 (25% x 4000) in its current fiscal year.
Gross loss
DTA is created when a company realizes gross loss in a particular year. As it creates an opportunity for a company to carry forward it to the next year to adjust with subsequent profits, thus reducing that year’s tax liability. DTA is recorded in the year when such loss is realised.
Deferred Tax Calculation
It is merely the difference between gross profit in a Profit & Loss Account and a tax statement. Let us take an example for a better understanding of its treatment:
| Particulars | As per Books (INR) | As per Tax (INR) |
| Total income | 1000000 | 1000000 |
| Expenses | 400000 | 400000 |
| Gross profit before depreciation and tax | 600000 | 600000 |
| Depreciation | 100000 | 80000 |
| Gross Profit after depreciation | 5000000 | 520000 |
Here, as the depreciation computed varies by INR 20,000, the taxable incomes in both cases also vary by the same amount. Hence, its tax liability shall be 25% on INR 5,20,000, i.e. INR 1,30,000. However, as per its books, its tax liability should have been INR 1,25,000. An additional INR 5,000 is payable as tax in the current year, and it creates a DTA.
Benefits of Deferred Tax
The difference between the two statements creates the scope for deferred tax. Thus, there is no pronounced benefit to it per se. However, recognizing such liabilities prepares the organization for future expenses. On the other hand, recognition of such assets can significantly reduce tax liabilities for the future.
FAQ
These assets and liabilities shall be measured at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled, based on existing tax rates at that time.
One should create either its liability or assets by debiting or crediting profit & loss a/c respectively. Furthermore, the deferred tax is to be created at the normal tax rate.
A deferred tax can surely be a company’s current asset as it helps in decreasing the taxable income. It appears on the company’s balance sheets under the heading of Current Asset itself.