Section 194C – TDS on Work Contract
April 20, 2018
Tax Deduction under Section 80RRB
April 20, 2018

Deferred Taxes and their Accounting

Last Update Date : April 20, 2018

Deferred taxes are an important part of your balance sheets. Therefore, it’s important to have a good idea about this concept. This article will give you a brief idea of what deferred taxes mean and how they reflect in your financial statements.

Deferred tax

Meaning of Deferred Taxes

Deferred tax is a form of tax which has been deducted in advance and can be subsequently carried forward or that will be payable in the future. The difference arising between accounting income and taxable income is known as deferred taxes. Tax effect of Deferred taxes is considered only if they arise due to temporary differences. IAS 12 requires that a deferred tax liability or asset is recorded in respect of all taxable temporary differences that exist at the year-end.

Objective of Deferred Taxes

Taxes on income is one of the most important items in an entity’s financial statement. Keeping the matching concept in mind, taxes on income accrue during the same period as revenue and expenses. However, in many cases, taxable income may differ from accounting income. These differences must be accounted for to give a fair view of the financial statements to the stakeholders and hence recognition criteria and accounting entries have been prescribed in IAS 12 for deferred taxes. These differences may arise due to two main reasons:

  • Difference in revenue and expenses reflecting in P&L account considered as revenue, expense or deduction for tax purposes.
  • Difference in amounts recorded as revenue or expenses in P&L account and that considered for taxation purposes. e.g., Rate of Depreciation differs as per Income Tax Act and Companies Act.

Important Terms related to Deferred Taxes

Listed below are a few important definitions necessary to understand the concept of deferred taxes:

  • Accounting Income / Loss: The net profit or loss reflecting in the “Statement of Profit or loss” before deducting or adding any income or expense for taxation purposes
  • Taxable Income / Loss: Income or Loss which is calculated based on tax laws to determine amount of Tax to be paid or recovered is known as taxable income or taxable loss
  • Current Tax: Amount of Income tax determined to be paid / recoverable during a period
  • Tax Expense: Aggregate of Current tax & Deferred tax charged to P&L account
  • Tax Savings: Aggregate of Current tax & Deferred tax credited to P&L account

Permanent and Temporary Differences

Difference between taxable income and accounting income can be classified into Permanent difference and temporary difference.

Permanent Difference

Those differences which originate in one period and are not capable of being reversed subsequently are known as permanent differences. e.g., Fines and penalties are disallowed as per tax laws but is considered as an expense for accounting purpose. Permanent differences do not result in deferred tax assets or deferred tax liabilities.

Timing Difference

When revenue and expenses are recorded while calculating taxable income and accounting income but the period for recording the same does not coincide, such differences are known as timing differences. Timing differences originate in one period and reverse subsequently during one or more periods. e.g., Depreciation method specified by tax laws is WDV, however for accounting purpose the entity chooses SLM. The total depreciation at the end of the life of the asset will be the same for both the methods, however it is recorded at different time periods.

Deferred Tax Asset & Deferred Tax Liability

Deferred Tax Asset (DTA)

Where the book profits in a year are less than taxable income, the excess tax paid today is known as Deferred Tax Asset. DTA is recognised only if there is future virtual certainty i.e. it is realized only when sufficient future taxable income can be reliably estimated.

Let us understand this with an example:

M/s Om Ltd which manufactures cars. The company assumes that the probability of a car being sent for warranty repairs is 1%. If M/s Om Ltd.’s revenue for financial year 2018 is Rs.22,00,000, then the following difference arises in the accounting income and taxable income.

Income as per Books of Account

Revenue Rs 22,00,000
Warranty Expense Rs 22,000
Income Rs 21,78,000
Tax Payable (Rate of Tax=30%) Rs 6,53,400

 

Taxable Income 

Revenue Rs 22,00,000
Warranty Expense Rs 0
Taxable Income Rs 22,00,000
Tax Payable (Rate of Tax=30%) Rs 6,60,000

The deferred tax asset based on the example above would be calculated as follows:
(Rs 6,60,000 – Rs 6,53,000) = Rs 6,600

Deferred Tax Liability (DTL)

Where the book profits in a year are more than taxable income, the deficit tax paid today is known as Deferred Tax Liability (DTL). The provision of virtual certainty is not applicable while recording DTL.

Let us take an example of the same company M/s OM Ltd which manufactures cars. Assuming that a fixed asset costs Rs 60,000 will last for 3 years. They will account Rs 20,000 p.a. as depreciation in P&L accounts by using SLM as the method of calculating depreciation. However as per the taxation laws depreciation is calculated differently.

Depreciation Year 1 Year 2 Year 3
As per Books of Accounts 20,000 20,000 20,000
As per Tax Laws 30,000 20,000 10,000
10,000 10,000
Tax at the rate 30% (3,000) 3,000
DTA/(DTL) DTL DTA

As shown above, The difference between the tax that the company should have paid on the basis of accounting and the tax that it actually paid shall amount to a deferred tax liability of Rs 3,000.

Effect of Tax Holidays

Deferred Taxes that originate and reverse during the tax holiday period should not be recognised by the entity. However, those Deferred taxes which originate during the tax holiday period and reverses after the holiday period must be taken into consideration by the entity. Such recognition must take place in the year of origination.

Let us understand this with an example.

Bk Ltd. established an entity during the year 2017 under section 10A. As per section 10A, BK ltd. shall be exempted from paying taxes from 2017-2027. Timing difference due to depreciation amounted to

  • Year 1: 50,000
  • Year 2: 40,000

Assuming the difference amounting to 30,000 will reverse before the end of tax holiday period, Deferred tax liability shall be calculated as shown below:

Timing Difference Difference after reversal DTL @ 30%
Rs. 50000 20000 = (50000-30000) 6000
Rs. 40000 40000 12000

*FIFO is used as the basis for adjustment. 

Since the entire depreciation for Year 2 is reversed after the tax holiday period, full amount shall be considered for DTL calculations.

Effect on Minimum Alternate Tax (MAT)

As per section 115JB of the Income Tax Act, Minimum Alternate Tax(MAT) is required to be paid by a company if the tax payable calculated as per the provisions of the income tax act is less than 18.5% of the book profits. Book profit for this purpose is to be calculated as per the provisions of section 115JB.

There are controversies if deferred tax liability debited to P&L should be added to the book profit for MAT calculations. There are contrary views regarding this issue by Kolkata Tribunal in Balrampur Chini and Chennai Tribunal in Prime Textiles Ltd case.

Presentation of Deferred Taxes in Financial Statements

Profit and Loss account

Journal entries:
1. Profit and loss account Dr. xxx
To Current tax Account xxx
(Being provision for current tax made)

2. Profit and loss account Dr. xxx
To Deferred Tax Account xxx
(Being Deferred tax liability created)

Balance Sheet

Deferred tax asset and deferred tax liability should be netted off and should be disclosed in the balance sheet. DTA and DTL, both should not be disclosed simultaneously for the same period. Deferred taxes are disclosed as current assets/liabilities under a separate heading in the balance sheet.

[If you find any picture of a Dummy B/S or P&L where DTA/DTL are shown please attach it here]

The objective of this guide is to give a brief understanding about DTA/DTL. Accounting treatment for deferred taxes are in accordance with that prescribed in IAS 12. Taxes on income is a significant item in the statement of profit and loss of an enterprise. If you are facing difficulties in understanding and meeting these requirements, you can raise your questions on TaxForum by H&R Block India where our tax experts will be happy to help you.

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