Updated on : May 12, - PM. This adjustment made at year-end closing of Books of Accounts affects the Income-tax outgo of the Business for that year as well as the years ahead. Company derives its book profits from the financial statements prepared in accordance with the rules of the Companies Act and calculates its taxable profit based on provision of the Income Tax Act.
There is a difference between the book profit and taxable profit because of certain items which are specifically allowed or disallowed each year for tax purposes. This difference between the book and the taxable income or expense is known as timing difference and it can be either of the following:.
The tax effect due to the timing differences is termed as deferred tax which literally refers to the taxes postponed. Deferred tax is recognised on all timing differences — Temporary and Permanent. These deferred taxes are given effect to in the financial statements through Deferred Tax Asset and Liability as under:.
With respect to timing differences related to unabsorbed depreciation or carry forward losses, DTA is recognised only if there is future virtual certainty.
It means DTA can be realised only when the company reliably estimates sufficient future taxable income. While computing future taxable income, only profits pertaining to business and profession should be considered and not the income from other sources.
A projection of future profits prepared by an entity based on the future restructuring, sales estimation, future capital expenditure past experience etc which are submitted to banks for loan is concrete evidence for virtual certainty.
Virtual certainty must be based on projections that are more likely in future. The fair value adjustments may not alter the tax base of the net assets and hence a temporary difference may arise. Goodwill Goodwill only arises on consolidation — it is not recognised as an asset within the individual financial statements. Theoretically, goodwill gives rise to a temporary difference that would result in a deferred tax liability as it is an asset with a carrying value within the group accounts but will have a nil tax base.
However, IAS 12 specifically excludes a deferred tax liability being recognised in respect of goodwill. Provisions for unrealised profits PUPs When goods are sold between group companies and remain in the inventory of the buying company at the year-end, an adjustment is made to remove the unrealised profit from the consolidated accounts. This adjustment also reduces the inventory to the original cost when a group company first purchased it. However, the tax base of the inventory will be based on individual financial statements and so will be at the higher transfer price.
Consequently, a deferred tax asset will arise. All of the goods remain in the inventory of S at the year-end. Normally, current tax rates are used to calculate deferred tax on the basis that they are a reasonable approximation of future tax rates and that it would be too unreliable to estimate future tax rates.
Deferred tax assets and liabilities represent future taxes that will be recovered or that will be payable. It may therefore be expected that they should be discounted to reflect the time value of money, which would be consistent with the way in which other liabilities are measured. IAS 12, however, does not permit or allow the discounting of deferred tax assets or liabilities on practical grounds.
The primary reason behind this is that it would be necessary for entities to determine when the future tax would be recovered or paid. In practice this is highly complex and subjective. Therefore, to require discounting of deferred tax liabilities would result in a high degree of unreliability. Furthermore, to allow but not require discounting would result in inconsistency and so a lack of comparability between entities.
As we have seen, IAS 12 considers deferred tax by taking a balance sheet approach to the accounting problem by considering temporary differences in terms of the difference between the carrying values and the tax values of assets and liabilities — also known as the valuation approach.
However, the valuation approach is applied regardless of whether the resulting deferred tax will meet the definition of an asset or liability in its own right. Thus, IAS 12 considers the overriding accounting issue behind deferred tax to be the application of matching — ensuring that the tax consequences of an item reported within the financial statements are reported in the same accounting period as the item itself.
For example, in the case of a revaluation surplus, since the gain has been recognised in the financial statements, the tax consequences of this gain should also be recognised — that is to say, a tax charge. In order to recognise a tax charge, it is necessary to complete the double entry by also recording a corresponding deferred tax liability. Therefore, the deferred tax liability arising on the revaluation gain should represent the current obligation to pay tax in the future when the asset is sold.
However, since there is no present obligation to sell the asset, there is no present obligation to pay the tax. Therefore, it is also acknowledged that IAS 12 is inconsistent with the Framework to the extent that a deferred tax asset or liability does not necessarily meet the definition of an asset or liability.
Deferred tax. Proforma Example 1 provides a proforma, which may be a useful format to deal with deferred tax within a published accounts question. The movement in the deferred tax liability in the year is recorded in the statement of profit or loss where: an increase in the liability, increases the tax expense a decrease in the liability, decreases the tax expense.
The statement of profit or loss As IAS 12 considers deferred tax from the perspective of temporary differences between the carrying value and tax base of assets and liabilities, the standard can be said to take a valuation approach. Example 1: Proforma. Table 2: Taxable profit and actual tax liability calculation Example 1. Table 3: Final tax expense for each reported income statement year Example 1. The paper F7 exam Deferred tax is consistently tested in the published accounts question of the Paper F7 exam.
The deferred tax liability given within the trial balance or draft financial statements will be the opening liability balance. It only exists on the balance sheet. Is a deferred tax asset a financial asset? Yes, a DTA is a financial asset because it represents a tax overpayment that can be redeemed in the future.
Where are deferred tax assets listed on the balance sheet? Note: While deferred tax assets can always be carried forward to future tax filings, they cannot be applied to tax filings in the past. What causes a deferred tax asset? How do deferred tax assets work? Examples of deferred tax assets Net operating loss : The business incurred a financial loss for that period.
Tax overpayment : You paid too much in taxes in the previous period. Business expenses : When expenses are recognized in one accounting method but not the other.
Revenue : Instances where revenue is collected during one accounting period, but recognized in another. When the unpaid receivable is finally recognized, that bad debt becomes a deferred tax asset. Is deferred tax liability a debt? A deferred tax liability journal entry represents a tax payment that, due to timing differences in accounting processes, the payment can be postponed until a later date.
Where are deferred tax liabilities listed on the balance sheet? A deferred tax liability is neutral or good, depending on your situation. The downside is that your business needs to have money set aside in order to pay this debt off in the future. What causes a deferred tax liability? How do deferred tax liabilities work?
This is the most common example of a deferred tax liability. Installment sale : When a product is paid for in installments, the company lists the full value of the sale in their balance sheet, but only pays taxes for each annual installment. The company recognizes that they have a deferred tax liability for future payments on that sale. Example in context Net operating loss carryforwards are a significant type of deferred tax.
Before you meet with essential stakeholders about financial matters, ask your CPA these types of questions: Of the netted figure on the balance sheet, what is the breakdown between deferred tax assets and deferred tax liabilities? What comprises the assets and liabilities? What events caused them? When do you expect the business to realize the tax assets and liabilities? Welcome My account Logout. Search site. Toggle navigation. Navigation Standards. Navigation International Accounting Standards.
Quick Article Links. Overview IAS 12 Income Taxes implements a so-called 'comprehensive balance sheet method' of accounting for income taxes which recognises both the current tax consequences of transactions and events and the future tax consequences of the future recovery or settlement of the carrying amount of an entity's assets and liabilities. In meeting this objective, IAS 12 notes the following: It is inherent in the recognition of an asset or liability that that asset or liability will be recovered or settled, and this recovery or settlement may give rise to future tax consequences which should be recognised at the same time as the asset or liability An entity should account for the tax consequences of transactions and other events in the same way it accounts for the transactions or other events themselves.
Key definitions [IAS IAS 12 provides the following guidance on determining tax bases: Assets. The tax base of an asset is the amount that will be deductible against taxable economic benefits from recovering the carrying amount of the asset. Where recovery of an asset will have no tax consequences, the tax base is equal to the carrying amount. The tax base of the recognised liability is its carrying amount, less revenue that will not be taxable in future periods [IAS The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods [IAS If items have a tax base but are not recognised in the statement of financial position, the carrying amount is nil [IAS If the tax base of an item is not immediately apparent, the tax base should effectively be determined in such as manner to ensure the future tax consequences of recovery or settlement of the item is recognised as a deferred tax amount [IAS In consolidated financial statements, the carrying amounts in the consolidated financial statements are used, and the tax bases determined by reference to any consolidated tax return or otherwise from the tax returns of each entity in the group.
The following are some basic examples: Property, plant and equipment. The tax base of property, plant and equipment that is depreciable for tax purposes that is used in the entity's operations is the unclaimed tax depreciation permitted as deduction in future periods Receivables. If receiving payment of the receivable has no tax consequences, its tax base is equal to its carrying amount Goodwill.
If goodwill is not recognised for tax purposes, its tax base is nil no deductions are available Revenue in advance.
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