Deferred Tax

5paisa Research Team Date: 22 Mar, 2023 06:24 PM IST


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Deferred tax is a key concept in accounting and financial statements, but understanding deferred tax can be tricky. So what is deferred tax exactly? Put simply, it is the difference between an asset or liability's carrying amount on a company's balance sheet and its respective income tax base.

Businesses must recognize deferred taxes when there are temporary differences between amounts reported for financial reporting and tax purposes. By understanding deferred tax, organizations can more accurately assess their financial position and plan for future liquidity needs. So let’s dive into deferred tax meaning and how it works!

What is Deferred Tax?

As per the deferred tax meaning,  it is an accounting treatment of taxes owed or paid in a different period compared to the one where the transaction occurred. This tax, also known as deferred income tax, is used when preparing financial statements according to Generally Accepted Accounting Principles (GAAP).

Deferred taxes are created when taxable income reported on a company's financial statements differs from what is being taxed. This difference between taxable income and actual taxes due can make deferred taxes appear on a balance sheet because they are treated as an asset or liability.

In simple terms, deferred tax liabilities refer to future taxes that will be due, while deferred tax assets are those that have already been paid but have yet to be reflected on the company's financial statements.

What is an Example of the Deferred Tax Liability?

An example of deferred tax liability would be a company that has incurred research and development (R&D) costs in one year but only realizes benefits from those costs several years later. The company may claim an R&D expense on its books for the current year but cannot yet deduct this amount to calculate its taxes. This deferred tax liability means that the company will need to pay taxes on the amount of the R&D expenses when it finally does recognize a benefit from them.

Deferred tax liability is simply an accounting term that describes the difference between a company’s taxable income in one period and its taxable income in another. This can happen when a company has deferred expenses, such as depreciation, amortization, or other costs incurred during the current year but not recognized until later. In this case, deferred taxes must be paid on those costs when they are eventually recognized.

Types of Deferred Tax

There are different types of deferred tax that can impact your financial statements. Generally, deferred taxes arise from temporary differences between the recorded amounts of assets and liabilities for income tax purposes versus their reported values for financial statement purposes. The different types of Deferred tax are as follows:

a)    Temporary Difference Deferred Tax: Temporary differences deferred tax account for the difference between what an asset or liability is worth for income tax purposes and its reported value on the financial statements. This type of deferred tax can also result from a current deduction taken in one period but only allowed to be deducted in future periods.

b)    Unrealized Loss Deferred Tax: Unrealized loss deferred tax accounts for losses that were incurred but cannot be realized later. This type of deferred tax arises when assets are written down, and the resulting write-down reduces taxable income while increasing deferred taxes due to the lower amount being taxed.

c)    Net Operating Loss (NOL) Carryforward Deferred Tax: NOL deferred tax is due when an entity has incurred a net operating loss in one period that can be carried forward and applied to reduce taxable income in future periods. This deferred tax liability occurs because the deferred tax expense reflects the amount of taxes that would have been due had the NOL not been available for carryforward.

By understanding these taxes and how they can impact your financial statements differently, you can make more informed financial decisions.

How is Deferred Tax Liability Calculated?

Deferred tax liability is calculated by taking the difference between a company’s current and taxable income for a specific period. This difference can be due to differences between how a company reports profits on its financial statements and calculates taxes for a particular period.

The deferred tax liability amount is then multiplied by the applicable tax rate to calculate what will have to be paid in deferred taxes at some point in the future. The calculation considers changes in legislation that may impact how much-deferred tax needs to be paid, such as when new regulations take effect or when a company’s assets have depreciated.

It is important to understand deferred tax for financial statements, as deferred taxes are liabilities that must be reported on the balance sheet. Companies can also use deferred taxes to plan their future income and expenses, helping them plan ahead and ensure they have enough funds available to pay their deferred taxes when the time comes.

Scenarios in which Deferred Tax is Recorded?

When recording deferred tax, businesses should consider a few scenarios that could potentially result in deferred tax. In general, deferred tax is the tax that a company has already paid or will pay in the future to meet its obligations for accounting purposes. Here are the main scenarios in which deferred tax is recorded:

Firstly, deferred tax can be recorded when taxes on income vary from the amount of taxes a company has already paid. For example, if income tax for one year was calculated at Rs.1,000, but the actual taxes paid was Rs.800, deferred tax of Rs.200 should be recorded for that year for income tax purposes. In other words, deferred tax is the amount yet to be paid and needs to be adjusted in the company’s books of accounts at the end of every financial year.

Secondly, deferred tax can also occur when there are differences between taxable profits and accounting profits due to deferred expenses or deferred incomes. For example, deferred tax liability would arise if an expense incurred during a particular period has been deferred till the next year while preparing financial accounts. Similarly, if income earned in a particular period has been deferred till next year while preparing accounts, deferred tax liability will also occur.

Lastly, deferred tax can arise when the carrying amount of an asset is shown in the books at a higher amount than its taxable value. This could happen due to different accounting and taxation policies followed by companies. For example, if a company has purchased an asset for Rs.10,000 but has been recorded as Rs.15,000 in their books of accounts, then a deferred tax of Rs.5000 will exist.

Is Deferred Tax Liability Good or Bad ?

Deferred tax liability is a tricky concept for many people to grasp. In short, deferred tax liability arises when taxable income and profits are not taxed in the current period but deferred until later. Taxpayers must still pay taxes at some point in time on any deferred tax liabilities; this deferred payment can be seen as either good or bad depending on the situation.

The most common instance of deferred tax liability is when businesses use accelerated depreciation methods for their assets rather than straight-line depreciation. This means they will pay less taxes during the year since they can deduct more from the cost of goods sold. However, they will have to pay deferred taxes once their assets become fully depreciated and no longer count towards the cost of goods sold.

On one hand, deferred tax liability is beneficial because it allows businesses to save money on taxes in the present and pay them at a later time. This can help manage cash flow better and enable businesses to invest more funds into growth strategies. 

On the other hand, deferred tax liabilities can be risky because taxpayers may find themselves with large amounts of deferred taxes due if their financial situation changes or needs to be managed properly. Therefore, deferred taxes should be carefully considered and managed as part of any company's overall tax strategy.

Unrealised Revenues and Expenses

Unrealised revenues and expenses are those payments that have been made or are due to be made but have not been recognised in the accounting records. This type of financial statement item is known as "unrealized gains and losses".

Unrealised revenues are money earned but not collected or recognized on the income statement. It can include payment for services rendered, interest earned from investments, or rent due from tenants. These amounts will only be recognised once the company has received them.

Unrealised expenses, on the other hand, relate to costs that still need to be paid. They could include advance payments for goods or services already received (which may be recorded as an asset until it is fully paid off) or taxes to be paid soon.

Un unrealised revenues and expenses can create discrepancies between the company’s book value (the amount in its financial records) and its market value, affecting its ability to obtain financing. Companies must manage their cash flow prudently to ensure that both types of payments are recognized and accounted for accurately.

Benefits of Deferred Tax

Here are the major benefits of Deferred tax:

1. The ability to plan taxes more effectively – Deferred tax allows you to better plan for your taxes by changing when certain income and expenses are recognized for accounting purposes.

2. Flexibility in retirement planning – Deferred taxes may allow you to save money on your tax bill while also helping you maximize savings potential during retirement.

3. A way to manage cash flow – By deferring taxes, businesses can better manage their cash flow. This is especially beneficial for small businesses with limited capital access or financing options.

4. Lowering the impact of volatile income streams – Deferring taxes can help smooth out the impacts of fluctuating income from year to year.

The Bottom Line

Deferred tax can be an important part of your business's financial planning, but it is something to approach cautiously. By understanding the basics of deferred taxes and staying on top of compliance, you can save yourself from unnecessary taxation and help ensure that your company gets the full benefits of this tool. 

With some research and preparation, you can ensure that deferred taxes are doing their job in supporting your business in the years ahead.

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