Deferred Tax in simpler terms
As per IAS 12, a Deferred Tax Liability is the income tax that will be due in the future because of taxable temporary differences.
To fully grasp this definition, we need to understand what temporary differences mean.
Temporary differences refer to the difference between an asset's carrying amount (CA) in the financial statement and its tax base (TB), which is the amount attributed to that asset or liability for tax purposes.
In financial statements, Non-Current Assets (NCA) are subjected to depreciation, while for tax purposes, NCA are subjected to tax deductions, also known as capital allowance.
The difference between the two depreciations results in a temporary difference between the carrying amount and the tax base.
To illustrate further, let's consider an example of a Non-Current Asset worth $1000 that was purchased at T0, which is depreciated on a straight-line basis over two years, with an annual depreciation of $500. The tax depreciation granted by the tax authority is T1 - $750 and T2 - $250.
The carrying amount of the asset at T1 is $500, while the tax base is $250. The temporary difference at T1 is $250 (500-250).
How does this example result in future tax payment?
Entities pay income tax on their taxable profits, which are calculated by adding back depreciation and deducting tax depreciation from the accounting profit and loss.
In the above example, the tax depreciation ($750) is greater than depreciation ($500) in T1. The entity has received early tax relief, and as a result, the payment of tax is deferred. However, this tax difference is temporary as tax will be paid in the future.
In year 2, when the tax depreciation ($250) is less than the depreciation charged ($500), the entity is liable to pay additional tax.
In accordance with the accrual and matching principle, revenue or expenses are recorded when a transaction occurs rather than when the payment is received or made. The matching principle also requires that revenue and expenses should be recognized in the same period.
Therefore, a Deferred Tax Liability is recorded, equal to the expected tax payable in the future.
Assuming a tax rate of 20%, the deferred tax liability recognized at T1 will be 20% x 250 = $50.
Please feel free to contact Cheylesmore Chartered Accountants for help sorting this out for you.
