Deferred tax is a topic that is regularly tested in Financial Reporting (FR) and is
often tested in further detail in Strategic Business Reporting (SBR). This article
will consider the aspects of deferred tax that are relevant to FR.
The basics
Deferred tax is accounted for in accordance with IAS® 12, Income Taxes. It is important
to note that references to ‘income tax’ here are to tax on company profits or losses
rather than tax on an individual’s income. Tax related to companies may be referred to
as ‘corporation tax’ or ‘corporate income tax’ in some jurisdictions.
In FR, deferred tax normally results in a liability being recognised within the statement of
financial position. IAS 12 defines a deferred tax liability as being the amount of income
tax payable in future periods in respect of taxable temporary differences. So, in simple
terms, deferred tax is tax that is payable in the future. However, to understand this
definition more fully, it is necessary to explain the term ‘temporary differences’.
Temporary differences are defined as being differences between the carrying amount of
an asset or liability in the statement of financial position and its tax base (ie the amount
attributed to that asset or liability for tax purposes).
Temporary differences may be either ‘taxable temporary differences’ or ‘deductible
temporary differences’.
Taxable temporary differences are those on which tax will be charged in the future when
the asset (or liability) is recovered (or settled).
Deductible temporary differences are those which will result in tax deductions or savings
in the future when the asset (or liability) is recovered (or settled).
IAS 12 requires that a deferred tax liability is recorded in respect of all taxable
temporary differences that exist at the year-end.
All of this terminology can be rather overwhelming and difficult to understand, so
consider it alongside an example. Depreciable non-current assets are a typical deferred
tax example used in FR to examine knowledge and understanding.
Within financial statements, non-current assets with a limited useful life are subject to
depreciation. However, within the corresponding tax computations, non-current assets
are subject to tax depreciation (sometimes known as ‘capital allowances’) at rates set
within the relevant tax legislation. Where at the year-end the accumulated depreciation
and the cumulative tax depreciation claimed are different, the carrying amount of the
asset (cost less accumulated depreciation) will then be different to its tax base (cost
less accumulated tax depreciation) and hence a temporary difference arises.
EXAMPLE 1
A non-current asset with a cost of $2,000 was acquired at the start of year 1. It is being
depreciated on a straight-line basis over four years, resulting in annual depreciation
charges of $500. Therefore, a total of $2,000 of depreciation will be charged over the
life of the asset. The tax depreciation granted by the tax authorities on this asset are:
Year 1 800
Year 2 600
Year 3 360
Year 4 240
2,000
Total tax depreciation
The table below shows the carrying amount of the asset, the tax base of the asset and
therefore the temporary difference at the end of each year:
Carrying Tax base
value (Cost less
(Cost less accumulated
accumulated tax Temporary
depreciation) depreciation) difference
Year $ $ $
1 1,500 1,200 300
2 1,000 600 400
3 500 240 260
4 - - -
As stated above, deferred tax liabilities arise on taxable temporary differences (i.e.
those temporary differences that result in tax being payable in the future as the
temporary difference reverses). So, how does the above example result in tax being
payable in the future?
Entities pay income tax on their taxable profits. When determining taxable profits, the
tax authorities start by taking the profit before tax (accounting profits) of an entity from
their financial statements and then make various adjustments. For example,
depreciation is considered a disallowable expense for taxation purposes but instead tax
relief on asset expenditure (capital expenditure) is granted in the form of tax
depreciation.
Therefore, taxable profits are arrived at by adding back depreciation and deducting tax
depreciation from the accounting profits. Entities are then charged tax at the appropriate
tax rate on these taxable profits.
In the above example, when the tax depreciation is greater than the depreciation
expense in years 1 and 2, the entity has received tax relief early. This is good for cash
flow in that it delays (i.e. defers) the payment of tax. However, the difference is only a
temporary difference and so the tax will have to be paid in the future. In years 3 and 4,
when the tax depreciation for the year is less than the depreciation charged, the entity is
being charged additional tax and the temporary difference is reversing. Hence the
temporary differences can be said to be taxable temporary differences.
Notice that overall, the accumulated depreciation and accumulated tax depreciation
both equal $2,000 – the cost of the asset – so over the four-year period, there is no
difference between the taxable profits and the profits per the financial statements.
Where local tax legislation requires that tax depreciation is calculated on a reducing
(diminishing) balance basis, then the asset may be fully depreciated before the full
amount of tax depreciation has been claimed. This does not make a difference to the
accounting required for deferred tax.
In this example, at the end of year 1 the entity has a temporary difference of $300,
which will result in tax being payable in the future (in years 3 and 4). In accordance with
the accruals concept, a liability is therefore recorded equal to the expected tax payable.
Assuming that the tax rate applicable to the company is 25%, the deferred tax liability
that will be recognised at the end of year 1 is 25% x $300 = $75. This will be recorded
by crediting (increasing) a deferred tax liability in the statement of financial position and
debiting (increasing) the income tax expense in the statement of profit or loss.
By the end of year 2, the entity has a taxable temporary difference of $400 (i.e. the $300
bought forward from year 1, plus the additional difference of $100 arising in year 2). A
liability is therefore now recorded equal to 25% x $400 = $100. Since there was a
liability of $75 recorded at the end of year 1, the double entry that is recorded in year 2
is to credit (increase) the liability and debit (increase) the income tax expense by $25.
At the end of year 3, the entity’s taxable temporary differences have decreased to $260
since the company has now been charged tax on the difference of $140 ($500
depreciation - $360 tax depreciation). In other words, they are now adding back more
depreciation in their tax computation than they are able to deduct in tax depreciation.
Therefore, in the future, the tax payable will be 25% x $260 = $65. The deferred tax
liability now needs to be reduced from $100 to $65 and so is debited (a decrease) by
$35. Consequently, there is now a credit (a decrease) to the income tax expense of
$35.
At the end of year 4, there are no taxable temporary differences since now the carrying
amount of the asset is equal to its tax base. Therefore, the opening liability of $65 needs
to be removed by a debit entry (a decrease) and hence there is a credit entry (a
decrease) of $65 to the income tax expense. This can all be summarised in the
following working:
1 2 3 4
Year
$ $ $ $
Opening deferred tax
0 75 100 65
liability
Increase/(decrease) in
75 25 (35) (65)
the year
Closing deferred tax
75 100 65 0
liability
The movements in the liability are recorded in the statement of profit or loss as part of
the income tax charge.
The closing figures are reported in the statement of financial position as part of the
deferred tax liability.
The statement of profit or loss
As IAS 12 considers deferred tax from the perspective of temporary differences
between the carrying amount and tax base of assets and liabilities, the standard can be
said to focus on the statement of financial position. However, it is helpful to consider the
effect on the statement of profit or loss.
Continuing with the previous example, suppose that the profit before tax of the entity for
each of years 1 to 4 is $10,000 (after charging depreciation). Since the tax rate is 25%,
it would then be logical to expect the income tax expense for each year to be $2,500.
However, income tax is based on taxable profits, not on the accounting profits.
The taxable profits and current tax liability for each year could be calculated as in the
table below:
Year Year Year Year
1 2 3 4
$ $ $ $
Profit before
10,000 10,000 10,000 10,000
tax
Add back
500 500 500 500
depreciation
Less tax
(800) (600) (360) (240)
depreciation
Taxable
9,700 9,900 10,140 10,260
profits
Tax liability 2,425 2,475 2,535 2,565
@ 25% of
taxable
Year Year Year Year
1 2 3 4
$ $ $ $
profits
The current tax liability is recorded as part of the income tax expense. As we have seen
in the example, accounting for deferred tax then results in a further increase or
decrease in the income tax expense. Therefore, the final income tax expense for each
year reported in the statement of profit or loss would be as follows:
Year Year Year Year
1 2 3 4
$ $ $ $
Income tax
expense related to 2,425 2,475 2,535 2,565
current tax payable
Increase/(decrease)
due to deferred tax 75 25 (35) (65)
Total income tax
(2,500) (2,500) (2,500) (2,500)
expense
It can therefore be said that accounting for deferred tax is ensuring that the matching
principle is applied. The income tax expense reported in each period is the tax
consequences (i.e. tax charges less tax relief) of the items reported within profit in that
period.
However, it should be noted that the tax consequences of transactions should be
accounted for in the same way that the underlying transaction is accounted for.
Therefore, if a transaction is accounted for outside of the statement of profit or loss
(either in other comprehensive income or directly in equity), then the tax effect should
also be recognised either in other comprehensive income or directly in equity as
appropriate. See Example 2 for further details.
The FR exam
Here are some hints on how to deal with questions about deferred tax when preparing
financial statements in the exam:
Any deferred tax liability given within the trial balance or draft financial statements is
likely to be the opening liability.
In the notes to the question, there will be information to enable you to calculate the
closing liability for the statement of financial position or the increase/decrease in the
liability.
It is important that you read the information carefully. You will need to ascertain exactly
what you are being told within the notes to the question and therefore how this relates to
the working that you can use to calculate the figures for the answer.
Consider the following sets of information – all of which will achieve the same ultimate
answer in the financial statements.
EXAMPLE 2
The trial balance shows a credit balance of $1,500 in respect of a deferred tax liability.
The notes to the question could contain one of the following sets of information:
1. At the year-end, the required deferred tax liability is $2,500.
2. At the year-end, it was determined that an increase in the deferred tax liability of $1,000
was required.
3. At the year-end, there are taxable temporary differences of $10,000. Tax is charged at a
rate of 25%.
4. During the year, taxable temporary differences increased by $4,000. Tax is charged at a
rate of 25%
$
Situation 1
Opening deferred tax 1,500 Provided in trial
liability balance
Increase in the year
(income tax 1,000 Balancing figure
expense)
Closing deferred tax Provided in
2,500
liability information
Situation 2
Opening deferred tax 1,500 Provided in trial
liability balance
Increase in the year
Provided in
(income tax 1,000
information
expense)
Closing deferred tax
2,500 Balancing figure
liability
$
Situation 3
Opening deferred tax Provided in trial
1,500
liability balance
Increase in the year
(income tax 1,000 Balancing figure
expense)
Calculated from
Closing deferred tax
2,500 information
liability
(25% x $10,000)
Situation 4
Opening deferred tax Provided in trial
1,500
liability balance
Increase in the year Calculated from
(income tax 1,000 information
expense) ($4,000 x 25%)
Closing deferred tax
2,500 Balancing figure
liability
Situations 1 and 2 are both giving a figure that can be included in the deferred tax
working. In situations 3 and 4 however, the temporary differences are being given.
These are then used to calculate a figure which can be included in the working. In all
situations, the missing figure is calculated as a balancing figure.
Revaluations of non-current assets
Revaluations of non-current assets are a further example of a taxable temporary
difference. When a non-current asset is revalued to its fair value within the financial
statements, the revaluation gain is recorded in equity (revaluation surplus) and reported
as other comprehensive income. While the carrying amount of the asset has increased,
the tax base of the asset remains the same and so a temporary difference arises.
Tax will become payable on the gain when the asset is sold and so the temporary
difference is taxable. Since the revaluation gain has been recognised within other
comprehensive income and included as part of equity, the tax charge on the surplus is
also recorded in other comprehensive income and reflected in the revaluation surplus
balance in equity. Suppose that in Example 1, the asset is revalued to $2,500 at the end
of year 2, as shown below:
Carrying Tax base
value (Cost less
(Cost less accumulated
accumulated tax Temporary
depreciation) depreciation) difference
Year 2 $ $ $
Opening
1,200 300
balance 1,500
Depreciation
charge / tax (600) 100
depreciation (500)
Carrying Tax base
value (Cost less
(Cost less accumulated
accumulated tax Temporary
depreciation) depreciation) difference
Year 2 $ $ $
Revaluation 1,500 - 1,500
Closing
600 1,900
balance 2,500
The carrying amount will now be $2,500 while the tax base remains at $600. This
results in a temporary difference of $1,900, of which $1,500 relates to the revaluation
gain. This gives rise to a deferred tax liability of $475 (25% x $1,900) at the year-end to
report in the statement of financial position. The liability was $75 at the end of the prior
year (Example 1) and thus there is an increase of $400 to record.
However, the increase in relation to the revaluation gain of $375 (25% x $1,500) will
therefore reduce the total recorded in the revaluation surplus to $1,125 ($1,500 - $375).
The revaluation gain itself can be presented in other comprehensive income net of tax
or can be shown gross (i.e. without netting off the tax). If the gross revaluation gain is
presented then the tax effect should be shown as a separate line item, aggregated with
the tax effect of any other items of other comprehensive income presented gross.
The remaining increase in deferred tax of $25 will be charged to the statement of profit
or loss as before. The overall journal entry required would be:
Dr Tax expense in Income Statement $25
Dr Revaluation reserve in equity $375
Cr Deferred tax liability in SFP $400
