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Deferred tax is an accounting concept (also known as future income taxes), meaning a future tax liability or asset, resulting from temporary differences or timing differences between the accounting value of assets and liabilities and their value for tax purposes.
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Temporary differences are differences between the carrying amount of an asset or liability recognized in the statements of financial position and the amount attributed to that asset or liability for tax which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled; or
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes:
The basic principle of accounting for deferred tax under a temporary difference approach can be illustrated using a common example in which a company has fixed assets which qualify for tax depreciation.
The following example assumes that a company purchases an asset for $1,000 which is depreciated for accounting purposes on a straight-line basis of five years. The company claims tax depreciation of 25% per year. The applicable rate of corporate income tax is assumed to be 35%. And then subtract the net value.
| Purchase | Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|---|
| Accounting value | $1,000 | $800 | $600 | $400 | $200 |
| Tax value | $1,000 | $750 | $563 | $422 | $316 |
| Taxable/(deductible) temporary difference | $0 | $50 | $37 | $(22) | $(116) |
| Deferred tax liability/(asset) at 35% | $0 | $18 | $13 | $(8) | $(41) |
As the tax value, or tax base, is lower than the accounting value, or book value, in years 1 and 2, the company should recognise a deferred tax liability. This also reflects the fact that the company has claimed tax depreciation in excess of the expense for accounting depreciation recorded in its accounts, whereas in the future the company should claim less tax depreciation in total than accounting depreciation in its accounts.
In years 3 and 4, the tax value exceeds the accounting value, therefore the company should recognise a deferred tax asset (subject to it having sufficient forecast profits so that it is able to utilise future tax deductions). This reflects the fact that the company expects to be able to claim tax depreciation in the future in excess of accounting depreciation.
Whereas International Financial Reporting Standards and US GAAP adopt a balance sheet approach in relation to deferred tax focused on temporary differences, certain GAAPs such as UK GAAP require deferred tax to be instead recognised in respect of timing differences.
A timing difference arises when an item of income or expense is recognised for tax purposes but not accounting purposes, or vice versa, and is therefore consistent with a profit and loss approach to deferred tax.
In many cases the deferred tax outcome will be similar for a temporary difference or timing difference approach. However, differences can arise such as in relation to revaluation of fixed assets qualifying for tax depreciation, which gives rise to a deferred tax asset under a balance sheet approach, but in general should have no impact under a timing difference approach.lll
Deferred tax is irrelevant to matching principle.
Deferred tax liabilities generally arise where tax relief is provided in advance of an accounting expense, or income is accrued but not taxed until received. Examples of such situations include:
Deferred tax assets generally arise where tax relief is provided after an expense is deducted for accounting purposes.Examples of such situations include:
Modern accounting standards typically require that a company provides for deferred tax in accordance with either the temporary difference or timing difference approach. Where a deferred tax liability or asset is recognised, the liability or asset should reduce over time (subject to new differences arising) as the temporary or timing difference reverses.
Under International Financial Reporting Standards, deferred tax should be accounted for using the principles in IAS 12: Income Taxes, which is similar (but not identical) to SFAS 109 under US GAAP. Both these accounting standards require a temporary difference approach.
Other accounting standards which deal with deferred tax include:
Management has an obligation to accurately report the true state of the company, and to make judgements and estimations where necessary. In the context of tax assets and liabilities, there must be a reasonable likelihood that the tax difference may be realised in future years.
For example, a tax asset may appear on the company's accounts due to losses in previous years (if carry-forward of tax losses is allowed). In this case a deferred tax asset should be recognised if and only if the management considered that there will be sufficient future taxable profit to utilise the tax loss.[2] If it becomes clear that the company does not expect to make profits in future years, the value of the tax asset has been impaired: in the estimation of management, the likelihood that this tax loss can be utilised in the future has significantly fallen.
In cases where the carrying value of tax assets or liabilities has changed, the company may need to do a write down, and in certain cases involving in particular a fundamental error, a restatement of its financial results from previous years. Such write-downs may involve either significant income or expenditure being recorded in the company's profit and loss for the financial year in which the write-down takes place.