Understanding Differed Tax

To understand deferred tax, it shall be noted at the outset that as per the accounting standards
followed by companies, (IFRS and GAAP) there are two different financial reports which an
organization prepares every fiscal year – an income statement and a tax statement. The
guidelines behind the preparation of a company’s income statement and tax statement are
slightly different. Hence, sometimes the numbers mentioned in both these reports might vary. It
is this disparity that creates the scope for deferred tax.

The term deferred tax, in essence, refers to the tax which shall either be paid or has already been
settled due to the inconsistency between an organization’s income statement and tax statement. A
deferred tax of any type is recorded in the balance sheet of an organization, It is crucial to note
that deferred tax is only recorded in the books of an organization if chances of a reduced or
increased tax liability in the future are more likely to occur than not. The concept of deferred tax
is rooted in the principles of true and fair view, regarding the subject of accounting in the
financial statements, means that the entity is required to charge so that the financial statements
present a true and fair view of the facts that are the subject of the accounting, and the financial
position of the entity. The view in the financial statements is true if the contents of the financial
statement items corresponds to the reality and is in accordance with appropriate accounting
principles, and methods. The display in the financial statements is true if they are prepared using
accounting principles and methods that lead to a fair presentation of the financial statements.

A deferred tax liability (DTL) or deferred tax asset (DTA) is created when there are temporary
differences between book (IFRS, GAAP) tax and actual income tax. There are numerous types of
transactions that can create temporary differences between pre-tax book income and taxable
income, thus creating deferred tax assets or liabilities.

The statement that deferred tax does not add value to the financial statement is debatable as
understanding changes in deferred tax assets and deferred tax liabilities allows for improved
forecasting of cash flows. An increase in deferred tax liabilities or a decrease in deferred tax
assets is a source of cash. Likewise, a decrease in the DTL or an increase in the DTA is a use of
 cash. Deferred tax assets lower the cash outflow; deferred tax liability increases the cash outflow
for the Company in the future. Analyzing the change in deferred tax balances should also help to
understand the future trend these balances are moving towards. Will the balances continue growing,
or is there a high likelihood of a reversal in the near future? These trends are often indicative of the
type of business undertaken by the company. For example, a growing deferred tax liability could
signal that a company is capital-intensive. This is because the purchase of new capital assets often
comes with accelerated tax depreciation that is larger than the decelerating depreciation of older
assets.

Secondly, deferred income tax affects the tax paid to the authorities for the financial year. It simply
refers to the tax that is overpaid or owed by the Company to the tax authorities. If there is a deferred
tax asset, the Company will have to pay less tax in the particular year, whereas, if there is a deferred
tax liability, it will have to pay more tax. Similarly, it is important to recognize deferred tax
liabilities because it helps the company be prepared for future expenses and plan its business
operations accordingly.

Financial analysis by construction of formulas for calculation of various financial ratios (profitability
indicators, in particular), is based on profit after tax (net profit). Failure to take into account deferred
income tax could then create the effect of distortion in the process of comparing the performance of
companies due to the over, or understatement, of net income. Deferred tax is an accounting category
that forms the part of tax expense and affects the reported amounts of profit after tax. It does not
affect the current income tax expense in the current period stated in the tax return; the tax authority
does not apply. Accounting for deferred income tax represents the assignment of costs incurred as a
result of the obligation to pay income tax for the correct accounting period, as well as revenue
generated as a result of entitlement to a reduction of income tax for the correct accounting period.

Finally as per taxation policies, tax cannot be levied on revenues which have yet not been realized by
companies. For instance, if there are unrealized receivables from debtors, then although as per
accounting laws it shall be recorded in the income statement; it is not considered for taxation. This
disparity in treatment of revenues creates a deferred tax liability because companies are required to
pay tax on a later date when they realize such receivables. At the same time, when there are expenses
which a company has recorded in its books but has not yet incurred is not considered for tax
calculations. Thereby, such company’s gross profit in its books is lower than what is shown in its tax
statement.

In conclusion it is the temporary difference in the two statements that creates the scope for deferred
tax; hence there is no pronounced benefit to it per se. However, recognizing such liabilities allows an
organization to be financially prepared for future expenses. On the other hand, recognition of
deferred tax assets can significantly reduce tax liabilities for the future. So whether to account for it
or not, rest solely on the entity in question.

Brealey, F.A. & Myers, S.C. (2000). Principles of Corporate Finance.6th edition, McGraw-Hill
New York

Schmidt. K. (2023, 04, January). Deferred Tax Liability or Asset. Retrieved from
https://corporatefinanceinstitute.com/resources/accounting/deferred-tax-liability-asset/

Shim, J. K. & Siegel, J. G. (2007). Financial management. (3rd ed.). McGraw-Hill, New York.
Wild, J.J. (2017). Financial Accounting: Information for Decisions. (8th ed.). McGraw-Hill
Education.

There are two types of deferred tax-deferred tax asset and deferred tax liability. When a company
pays its tax liability for another period in advance or is able to reduce its tax liability for a
subsequent period in a particular, fiscal year, then that is recorded as deferred tax asset. On the
other hand tax that is accumulated in a particular year, but such company is liable to settle it in a
subsequent fiscal year, then it shall be considered as a deferred tax liability. In other words, a
deferred tax liability is created when there is a timing difference between when a tax liability
accrues and when a company is liable to pay it.