This article has been written by Ishani Samajpati, pursuing B.A. LL.B. (Hons) under the University of Calcutta. The article explores the underlying concept of deferred tax, how deferred tax occurs, and how deferred tax assets and deferred tax liabilities are accounted for.

This article has been published by Sneha Mahawar.​​ 

Introduction

The term ‘tax’ is usually related to the contribution of an individual to the state revenue, paid to the government, over a period of time. However, the concept of deferred tax is completely different from all the commonly known taxes levied by the government. 

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The word ‘deferred’ means ‘postponing any action,” while tax refers to the amount of money contributed by an individual to the state’s revenue, levied by the government. In simple words, deferred tax is the tax payable at a later date or time. 

Discussion about deferred taxes, its various aspects, related concepts and how deferred tax is completely different from other commonly known taxes are further discussed elaborately in this article.

What is deferred tax

The term ‘deferred tax’ refers to the approximate amount of tax payable in the future. Deferred tax is the amount of income tax to be paid in the future in order to adjust any differences that arise due to taxable profits and accounting profits.

The deferred tax amount in the financial statement is not an amount to be paid but is just an amount as a result of the difference between the calculation based on accounting standards versus the calculation based on tax regulations. It should be kept in mind that deferred tax is calculated solely for accounting purposes and the tax amount is not paid in reality. Rather, it is calculated to adjust the temporary differences between the income statement and the tax statement. Deferred tax is also not refundable from the revenue authority.

The deferred tax is usually seen on the balance sheet of any company. The financial statements of the balance sheet of any company usually consist of the taxes payable in the current year and the deferred taxes. 

Every company prepares two types of financial reports in any financial year. One is the financial report containing an income statement of the company, and another one contains the tax statement of the company. This helps a company directly monitor the income generated and the amount of taxes paid in any particular financial year, thereby making the calculation of profit and loss easier. However, the amounts mentioned in the two statements may vary sometimes, often due to the present and past transactions. That is when the term ‘deferred tax’ comes into play.

Temporary differences in deferred tax

Deferred taxes are mainly created because of the temporary difference. Temporary differences are the differences that occur as a result of the difference between the carrying amount of an asset or liability in the statement of financial position and its tax base. The tax base of an asset or liability is the total amount or value attributable to that asset or liability for tax purposes. It is calculated on the basis of tax rules in a specific country.

The difference in tax arises because of the taxable incomes or profits earned by a company and the reported amount in the financial statements. It results in a future tax-deductible amount. The temporary difference results in deferred tax. The difference would eventually get reversed. 

Sometimes, temporary differences are created where revenues are taxable after they are recognised in the financial statement. Any receivable accounts or investments may be recognised for revenues that will result in taxable amounts in future years (deferred tax liability) when the asset is recovered.

Creation of temporary differences

Following are some examples of situations where temporary differences are created. 

i) Products sold in equated monthly installments (EMIs).

ii) Contracts accounted for under the percentage of completion method for financial reporting purposes.

iii) Investments where the return is due in the future.

In all these cases, revenue will be gained in the future. The amount has to be reported in the financial statement but not in the income statement, thus giving rise to a temporary timing difference.

Types of temporary differences

Temporary differences can be any of the following two cases:

  • Deductible temporary difference in case of deferred tax asset; and
  • Taxable temporary difference in case of deferred tax liability.

Reasons deferred taxes occur

Before discussing deferred tax, a basic concept of how taxation is normally calculated and mentioned in balance sheets is discussed. In normal circumstances, when a company is profitable, the revenue earned by the company and the cost incurred is added and the result is the earnings by the company before taxation. After applying the current tax rate levied by the government, the income tax expense will be deducted from the earnings before taxation, and the result will be the net income earned by the company for that particular financial year.

The entry for recording the income tax expense will be mentioned as the debit income tax expense in the income statement and credit income tax payable on the balance sheet. When the payable tax is subsequently transferred to the tax authorities, the payable income tax is debited and cash is credited.

The above-mentioned situation applies to a company that regularly generates profit. But in the case of a newly-formed or start-up company that has not generated any profit until now, the situation is completely different. That is when the deferred tax occurs.

Deferred tax arises because there are differences between taxable profits and accounting profits. Since the companies calculate both the taxable and accounting profits, some differences arise due to the application of different provisions of law. These temporary differences are accounted for, recognized and carried forward in the books of accounts. Accordingly, two types of deferred taxes are created. They are deferred tax assets and deferred tax liabilities, respectively. 

Deferred tax assets 

Deferred tax assets are created whenever taxable profit is more than the profit mentioned in the books of accounts. 

Occurrence 

Even if a company does not generate any revenue in the first year, it incurs costs and therefore generates negative earnings before tax. The income tax expense on those earnings before tax and the net income is also negative. In this situation, the company has to suffer losses in that particular year, and the tax deduction becomes more than the profit generated. However, the tax relief is given in the form of Net Operating Loss (NOL) Carryforward, i.e., the company has to adjust its losses from the initial years with profits from subsequent years. In the case of an NOL, the company does not owe any taxes. The payable income tax is calculated as the deferred tax asset on the balance sheet.

For example, let us take the case of a domestic company in India named X. In a particular financial year, it earned a revenue of Rs 1,000,000 and incurred a cost of Rs 9,00,000. Therefore, the earnings before taxes of the company are revenue minus cost, i.e., Rs. 100,000. Then, at a tax rate of 25%, the income tax expense will be  Rs 25,000 and the net income will be Rs 75,000.

Here, the journal entry for recording the income tax expense is debit income tax expense in the income statement and credit income tax payable on the balance sheet. Once the tax payable is transferred to the tax authorities, the income tax payable is debited and the cash is credited.

Now, let us take the case of a startup named Y, which did not generate any profit in the first year, but incurred costs, thus creating negative earnings before tax. Hence, the income tax expense and the net income is subsequently negative. Here, Y should apply Net Operating Loss Carryforward, i.e. it should adjust the loss in the first year with the profit of the next year.

The negative income tax payable by startup Y is mentioned as the debited deferred tax asset in the balance sheet and credited income tax expense in the income statement.

Deferred tax assets on the balance sheet

The way the negative income tax gets booked is to credit income tax in the income statement and debit deferred tax assets on the balance sheet.  Deferred tax assets reduce the amount of taxes paid in future periods. 

For example, a newly formed company or startup generated no profit in the first year. So, it carries on the deferred tax asset on the balance sheet in the next year and generates a certain amount of revenue and earnings before tax. On these earnings before tax, an income tax charge equal to the amount of deferred tax is recorded.

In terms of journal entries, the income tax expense is debited in the income statement, and instead of crediting income tax payable on the balance sheet, the deferred tax asset is credited and depleted.

Hence, the company adjusted its loss in the first year with the profit in the subsequent year.

Creation of deferred tax assets

The common denominators of deferred tax assets are the temporary timing differences between tax and book accounting. Deferred tax assets occur when taxable income is higher than the accounting income. Some of the items that may create deferred tax assets are pensions, employee benefit plans, non-deductible reserves, accruals, allowances and claims, etc.

Deferred tax asset impairment

Deferred tax asset impairment is the reduction or decrease of the balance sheet asset. Such a decrease occurs when there is a tax rate change or when there is a change in the likelihood of being able to recover deferred tax assets against future sources of taxable income. 

Deferred tax liabilities

On the other hand, deferred tax liabilities are created when the taxable profit is less than the accounting profit and there are temporary differences between the accounting tax and the actual payable income tax.  

Occurrence

Deferred tax liability occurs when an obligation to pay income tax arises in one particular financial year but the income tax is due to be paid in another subsequent year. In simple words, deferred tax liability signifies that a company has to pay more income taxes in the future period. It occurs when the company postpones an event that would be recognised as an income tax expense. 

Deferred tax liabilities are also created when the government and the tax legislators allow corporations to pay their corporate income taxes at a much later date. The main reason for providing this incentive to corporations is to give them a chance to increase their capital investment, which in turn helps to create more job opportunities. 

Deferred tax liabilities in real life

Some of the examples of deferred tax liabilities in real life are as follows:

Expense of depreciation

Expense of depreciation caused due to different calculations by tax laws and accounting rules is one of the main reasons behind deferred tax liability. In India, depreciation is calculated differently in the Income Tax Act, 1961 and the Companies Act, 2013. 

Products sold on EMIs

The products sold on equated monthly installments (EMIs) to customers create deferred tax liabilities on the companies since the sale took place at a much earlier date but the income tax will be paid on a much later date. In this case, the obligation to pay tax is created immediately the moment the product is sold to a customer, but the tax is to be paid only after the customer completes all the EMIs.

Conclusion

The recognition of a deferred tax asset or a deferred tax liability at the end of each accounting period is required by the Indian Accounting Standards (Ind AS). The temporary differences lead to the creation of a deferred tax asset or liability. Where the book profit is higher than the taxable profit, a deferred tax liability gets created, and alternatively, where the book profit is lower than the taxable profit, a deferred tax asset gets created. 

Frequently asked questions (FAQs) on deferred taxes

What is deferred tax?

Deferred tax is the estimated amount of future tax payable as a result of current and past transactions by a company in the financial statements. It is used as an accounting entry and not the actual tax payable to or refundable from the tax authorities of the government.

Why do deferred taxes occur?

Deferred taxes occur as a result of temporary differences in the accounting profits and taxable profits.

What are the two kinds of deferred taxes?

Two kinds of deferred taxes are deferred tax assets and deferred tax liabilities.

What are the benefits of the calculation of deferred tax?

Deferred tax predicts the estimated amount of future tax payable by a company. It also offers a glimpse of the profit and loss status of the company. Apart from that, the calculation of deferred tax is required by Indian Accounting Standards.

References

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