Every profitable company is liable to pay income tax, however, the income tax is not calculated on the basis of accounting profit, rather it is calculated on the basis of profit calculated under applicable tax regime which may differ from accounting profit.
Tax provision allow claim of certain expenses on fulfillment of certain condition or at a specific time which may be different from a company’s accounting policy for claiming such expenses. This result in temporary differences between accounting and tax profits for the year. For example, in Pakistan:
- Tax laws allow initial tax allowance of upto 90% on capital expenditure in some cases which reduces taxable profit in initial years. On the other hand in accounting profit there is no such adjustment which creates a temporary difference
- Tax laws allow depreciation on reducing balance methods and at specified rates. If company has different depreciation rates or is using straight line or any other depreciation method, it will again result in temporary difference
- In accounting records, provision for doubtful debts is recognized as expense way before the actual write off while tax laws allows claim of bad debt expense only when non-recoverability of debt is confirmed and debts are written off. This creates a temporary difference between accounting and tax profits.
Temporary differences can result in huge gap in tax amounts for different financial years and results in significant fluctuations in after tax profits of the company even in the presence of stable operational results otherwise. Deferred tax asset/ liability is booked in accounts to neutralize those temporary/timing differences arising due to accounting policies followed by the business and the treatments allowed under tax laws.
Depending upon nature of temporary differences, following two types of deferred tax provision can be recognized:
|1||Deferred tax asset||Recognizes the amount that is being paid as tax today due to temporary differences but will not have to be paid in future.|
|2||Deferred tax liability||Recognizes the amount that is not being paid today due to temporary differences but will have to be paid in future.|
Example and justification for deferred tax:
Assume following data for a company from year 2015 to 2017:
- Company purchased a fixed asset at the start of year amounting $ 1,000,000
- Accounting profit before tax is $ 500,000 each year.
- Accounting depreciation calculated at straight line method @ 33.33%
- For tax purposes, an initial allowance of 25% and depreciation on reducing balance @ 40% is allowed.
- Corporate Tax rate is 35%
Based on above assumptions, calculation of depreciation under accounting policy and as allowed under tax rules would be as follows:
Based on above calculation, tax profit and provision for tax payable for the year would be calculated as follows:
If deferred tax provision in not recognized, then Profit and loss Account would look like as follows:
Now see that if deferred tax is not recognized, provision for taxation isfluctuating significantly each year and so is the profit after tax figure despite same profit before tax in each year. The fluctuation is only due to temporary timing differences between accounting policy and tax rules on the claiming of depreciation expense otherwise there is no difference between size of operations or gross margin or other factors affecting company’s profitability and the fluctuation in profit after tax over the years might give wrong information to the users of financial statements.
Deferred tax provision is recognized to rectify above issues. Based on above data, deferred tax would be computed as follows:
Following accounting entries would be recorded in respective years to recognize the normal and deferred tax provisions.
The Profit and Loss account after recognition of deferred tax would be as follows:
Now see how deferred tax has neutralized the temporary differences. During year 2015 tax rules allowed an accelerated depreciation (initial allowance + depreciation at a higher rate) which reduced the taxable profit and ultimately the amount of tax payable giving a temporary gain. Moreover, due to reducing balance method under tax laws, lesser tax depreciation will be allowed in next tax years ultimately increasing the amount of tax payable in later years and giving a temporary loss. By recognizing the deferred tax provision we have eliminated the respective temporary gains and losses and as a result, the after tax results of all years are much more comparable and matching to actual operational results.
The Balance sheet after recognition of deferred tax would be as follows: