Deferred Tax is a subject that has cropped in in my F2 studies and I’ve realised it’s not such a difficult topic to understand.
In my working experience, deferred tax is a not a subject most finance professionals want to even look at. “Let the tax department handle it” or “speak to the business controller” are the usual responses when deferred tax is mentioned in the office. So this mindset already clouded my judgement when thinking about it.
But here is my (simple as possible) explanation on how deferred tax works.
What is Deferred Tax?
It’s basically creating a provision (deferred tax liability) or a prepayment (deferred tax asset) due to temporary differences that arise when calculating the tax payable.
There is no movement of cash to consider but just a release of the provision/prepayment created once the temporary differences have reversed themselves.
There are two types of differences when calculating tax.
Permanent differences and Temporary differences, but for deferred tax purposes we are only concerned with the calculation of the Temporary differences.
Below is an illustration on both types of differences.
Calculating Deferred Tax
As mentioned above, the deferred tax charge can be calculated using two different methods. The timing difference approach and the temporary difference but not to get to bogged in information we don’t need I have calculated the deferred tax using the temporary difference approach as stated in IAS 12.
Here is the scenario and the steps I took in the above example.
Temporary Difference Scenario
- Company A purchases a new fixed asset for 750
- Tax relief of 100% has been given to the purchase of a new asset of 750 in year 1.
- The useful life of the asset is three years and will be depreciated fully in that time.
Temporary Difference Calculation
- We are concerned with the Statement of Financial Position (balance sheet) when using this approach.
- Calculate the net value of the assets for accounting purposes and tax purposes.
- The tax rate is applied to the difference between the accounting and tax net values.
- In year 1, the deferred tax amount is 50 (500 x 10% tax rate)
The deferred tax entry for year 1 would be:
DR – 50 Tax Charge (income statement) CR – 50 Deferred Tax Liability (SOFP)
Then, in year 2, the deferred tax liability on the SOFP should be reduced to 25 so the accounting entries would be as follows:
DR – 25 Deferred Tax Liability (SOFP) CR – 25 Tax Charge (income statement)
Deferred Tax Assets
I’ve looked at the creation a deferred tax liability in the above example but in some cases, the deferred tax calculation will arise in an asset being created.
Here are the following situations that would see a creation of a deferred tax asset.
- A deductible temporary difference
- Unused tax losses
- Unused tax credit
Simply put, a deferred tax asset is an amount that a company can deduct from future tax liability to reduce the tax bill. For example, a company has unused tax losses of 5000 and the tax rate is 25% – therefore the deferred tax asset is calculated as 5000 x 25% = 1250