The book value or carrying of an asset defines its cost less any accumulated depreciation over its life. Sometimes, if a company choose to use the fair value method of valuing its assets, their book value will represent the revalued cost of the assets less any accumulated depreciation. Apart from accumulated depreciation, the carrying value of assets also decreases due to any impairments, although these instances are rare. The book value of the assets of a company is a part of its Statement of Financial Position. The higher the book value of these assets is, the better the company’s financial position is.
On the other hand, assets may also have a tax value. The tax value of an asset may be similar to its book value. However, most often than not, the tax value and the book value of the assets of a company will not match. That is mainly because under some tax laws some accounting treatments may not be acceptable. Therefore, companies may have to recalculate or even remove the accounting treatment when deriving the tax value of their assets.
For example, companies charge depreciation based on judgment on their assets to derive the book value of those assets. In most jurisdictions, the depreciation charged under accounting rules is unacceptable for tax purposes. Therefore, tax laws dictate companies to calculate depreciation using tax laws rather than accounting laws. Apart from depreciation, there can also be other reasons which may cause the tax value of assets to be different from their book value.
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What is Deferred Tax?
Deferred tax is an accounting concept in accounting that requires companies to match the tax effects of transactions with their accounting treatment. In the case of assets, deferred tax is an adjustment created due to a difference in its tax value and book value. Deferred tax does not represent actual tax payable or receivable by a company from the government. Instead, it is an accounting concept used by companies to adjust for the effects of the difference between the tax base and book value of items.
As mentioned above, the value of assets as per accounting standards and as per tax laws may not be the same for a company. However, those differences don’t only exist in assets. The value of the liabilities of a company may also be different from the tax value of those liabilities. Similarly, some other expenses and incomes may also have different accounting and tax treatment. Deferred taxation is also necessary in those cases to adjust for the differences between the book value and the tax base of the items. For example, unearned revenue, according to accounting standards, is a liability. In most tax laws, it is taxable income. Therefore, the difference between these two exists.
What is a Temporary Difference?
Companies recognize deferred tax due to a temporary difference in the tax base of certain items and their accounting treatment. Temporary differences are differences that resolve themselves over time and are not permanent. Therefore, we can define a temporary difference as the difference between the carrying amount of an item and its related tax base. In case of permanent differences between these values, there is no deferred tax accounting treatment.
Temporary differences are different from permanent differences. Temporary differences arise when an adjustment is allowed under both accounting and tax rules. However, there’s a difference in the timing of these allowances. Therefore, there is a difference between the values of both laws. This difference resolves over time. On the other hand, a permanent difference is when an adjustment is not allowed under either accounting or tax laws. These differences do not resolve over time and always remain.
Temporary differences can create two types of deferred tax treatments for companies. That is because the tax base of an asset or liability can either be higher or lower than its carrying value in the accounting system of a company. Therefore, the differences may require the company to either recognize a deferred tax asset or a deferred tax liability, based on whether the tax base is higher or lower and whether the considered item is an asset or a liability.
Deferred Tax Liability
Deferred tax liabilities are more common as compared to deferred tax assets. A deferred tax liability arises when the carrying amount of an asset or liability exceeds its tax base. In this case, the temporary difference is also known as a taxable temporary difference. As the name suggests, companies must recognize taxable temporary differences as a liability. A taxable temporary difference is a difference that will result in taxable amounts in the future when determining taxable incomes.
Deferred Tax Asset
Deferred tax asset is the opposite of deferred tax liability. A deferred tax asset arises when the tax base of an asset or liability exceeds its carrying amount. In the case of deferred tax assets, the temporary difference is known as a deductible temporary difference. It is because the difference will result in amounts that a company can deduct in the future when calculating its taxable income. For the company, a deductible temporary difference is an asset.
The standard that deals with deferred tax in accounting allows companies to offset deferred tax assets and deferred tax liabilities. However, there are some conditions attached to it. The standard requires companies to have a legally enforceable right to set off current tax assets and current tax liabilities. Similarly, it requires the deferred tax assets and liabilities to relate to the tax levied by the same tax authority. That means the company cannot offset deferred tax assets against deferred tax liabilities caused by tax laws of a different jurisdiction.
How to Account for Deferred Tax?
Accounting for deferred tax is straightforward. A company must recognize deferred tax assets and liability according to the requirements of the International Financial Reporting Standard IAS 12 – Income Taxes. The important thing before the recognition of deferred tax for the company is to determine the tax base and carrying amount of the asset or liability to which the deferred tax relates.
Once the company determines the difference between the two, it can also determine whether the difference is temporary or permanent and whether the temporary difference is taxable or deductible. The company must also multiply the difference with the applicable tax rate for the jurisdiction in which it operates to reach the amount which it must recognize as asset or liability.
In the below section, we cover the accounting for both deferred tax assets and deferred tax liabilities.
Accounting Entries for Deferred Tax Assets
In the case of a taxable temporary difference, the company must recognize a deferred tax liability. The accounting treatment for recognizing a deferred tax liability is as follows.
Dr. Tax expense
Cr. Deferred tax liability
The tax expense will go into either the Statement of Profit or Loss or the Statement of Other Comprehensive Income depending on which item the deferred tax relates to.
Accounting Entries for Deferred Tax Liabilities
On the other hand, a deductible temporary difference requires the company to recognize a deferred tax asset in its accounts. The accounting treatment for recognizing a deferred tax asset is as follows.
Dr. Deferred tax asset
Cr. Tax expense
The tax expense recognized with a deferred tax asset reduces the tax expense of a company for a specific accounting period.
The deferred tax asset and liability become a part of the Statement of Financial Position of a company. The balances get carried over each year. The company must determine the tax base and the carrying value of the underlying asset or liability each year and adjust the deferred tax asset or liability accordingly. When the tax base and carrying value of the asset or liability match each other, the company can write off the balance. Thus, proper accounting for deferred tax assets and deferred tax liabilities is important.
Does Deferred Tax Affect Cash Flow?
The deferred tax of a company does not represent a cash transaction, but rather an amount that it must recognize per the accounting standards. Therefore, the deferred tax does not affect its cash flow. However, that does not mean the deferred tax of the company will not be a part of its Statement of Cash Flows.
There are two methods in which entities can present their Statement of Cash Flow, direct method and indirect method. Deferred tax adjustments are not a part of the statement prepared under the direct method. However, under the indirect method, which is more common than the direct method, companies must show deferred tax in the operating cash flow section as an adjustment to the profit/loss before tax amount. Therefore, an increase or decrease in deferred tax can affect the cash flow of a company prepared under the indirect method. However, it does not affect its cash flows.
Deferred tax is an accounting concept that requires companies to recognize any temporary differences between the tax base and carrying amount of their assets and liabilities. There are two types of temporary differences. The first type is taxable temporary differences, which gives rise to deferred tax liability. The second type is deductible temporary difference, which gives rise to a deferred tax asset. The accounting treatment of deferred tax has an impact on both the Statement of Profit or Loss and the Statement of Financial Position.