Understanding Deferred Tax in Income Tax Accounting in 11 Easy Steps

Accounting for income tax and its deferred tax components are the focus of IAS 12, Income Tax . It has been a notorious IAS for student and practitioners alike to grapple with. But in this article cum tutorial we shall look at how it is handled in the financial statements.

 

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Step 1: What is Income Tax?

Income tax is the tax levied on the income of businesses, organizations and individuals. Income tax can be categorized into two (2) namely, personal income tax and company income tax.

 

Personal income tax is an income tax levied by the government on the income of individuals from different sources such as salaries and wages, rent income etc. On the other hand, company income tax is the income tax levied by the government on the incomes or profits of incorporated businesses.

 

The focus of this tutorial is how to account for company income tax and its deferred tax aspect.

 

Step 2: What is Deferred Tax?

Now that you know what income tax is, what then is deferred tax? What has deferred tax got to do with income tax? In accordance with IAS 12, Income Tax, income tax or company income tax should not be accounted for, without accounting for its deferred tax aspect. This then gives weight to the need for a thorough knowledge of how to account for deferred tax in the financial statements.

 

What then is deferred tax seeing that it is an important component of income tax?

 

A deferred tax can be defined as the amount of tax payable or recoverable (or savings) from future periods on either taxable or deductible temporary difference. But is this definition illuminative enough?

 

To keep it simple, deferred tax is the amount of income tax to be paid or income tax savings in future periods due to the differences between the carrying amounts of the assets and liabilities in the statement of financial position and the values attributed to them for tax purpose. Still grappling with understanding this definition because of some of the key words in it? Then please, pay close attention to the next step.

 

Step 3: Carrying Amount Vs Tax Base

Now to begin with; assets are usually acquired by businesses, and liabilities incurred by them. These (i.e. the assets and liabilities) are recorded in the books of account by the business concerned, and at each period end their (i.e. assets and liabilities) values are adjusted or updated as appropriate. The values of the assets and liabilities in the books of account or the financial statements of a business or organization are known as CARRYING AMOUNT or CARRYING VALUE (whichever is more convenient for you to use).

 

But on the other hand, in computing the tax payable (i.e. current tax payable) by a business or organization, a tax authority (i.e. Inland Revenue) usually attributes values to its (i.e. a company’s) various assets and liabilities. These values ascribed or attributed by the tax authority (i.e. Inland Revenue) to these assets and liabilities for tax purposes are called TAX BASE or TAX VALUE.

 

More often than not, there are differences between the assets and liabilities’ carrying amounts and their tax bases or tax values, and some of these differences usually lead to a difference between the accounting profit of a business (or company) and the taxable profit on which the current tax payable is computed.

 

For exemplification of an asset’s carrying amount and its tax base, please consider this illustration.

 

ILLUSTRATION 1:

Lois Ltd acquired a motor vehicle on January 1, 2000 at a cost of N 1,000,000.00 with an estimated useful life of 5 years. It is the company’s policy to depreciate its assets on a straight-line basis. For tax purposes, the tax authority allows a capital allowance of 25% on motor vehicles. Find:

1. The carrying amount of the motor vehicle as at December 31, 2000.
2.  The tax base of the motor vehicle as at December 31, 2000.

SOLUTION 1:

1. The carrying amount of the motor vehicle as at December 31, 2000 is the original cost      less the accumulated depreciation and impairment losses (if any) to that date. This is calculated as:

= N 1,000,000.00 – (N1,000,000.00/5 years)

= N 1,000,000.00 - N200,000.00

= N 800,000.00

2. The tax base of the motor vehicle as at December 31, 2000 is the original cost less the accumulated capital allowance to date to get the tax written down value. This is calculated as:

= N 1,000,000.00 – (25% X N 1,000,000.00)

= N 1,000,000.00 - N 250,000.00

=N 750,000.00

 

Step 4: Why deferred tax provision?

Before we go on, you might ask yourself why we have to go through the hassle of making deferred tax provision. Why deferred tax? Why do we have to provide for deferred tax? Or why do we have to provide for the tax to be paid or recovered in future periods due to the differences in the carrying values and tax bases of a company’s assets and liabilities?

 

There are reasons, and here are they:

 

1. With provision for deferred tax (either deferred tax asset or deferred tax liability), there is a constant effective tax rate over time. That is, if the tax expense for each period is computed as a percentage of the accounting profit (i.e. Tax Expense/Accounting Profit), this will give a constant tax rate for all the periods under consideration. There will never be a constant tax rate if no provision is made for deferred tax.
2. Accounting for deferred tax helps in providing for the tax consequences that might occur in future periods due at times, to the differences in the period that transactions are dealt with in the financial statements, and the period in which they are accounted for, for tax purpose.

Provision for deferred tax can either be a deferred tax asset or a deferred tax liability.

 

Step 5: Types of Differences between Carrying Amount and Tax Base

In step 3 above under carrying amount vs. tax base, I mentioned that differences can occur between the carrying amounts and tax bases of assets or liabilities. I equally mentioned that these differences more often result in disparity between a company’s accounting profit and the taxable profit used in computing the current tax payable.

 

A difference can be of various types: These are TIMING DIFFERENCE, PERMANENT DIFFERENCE and TEMPORARY DIFFERENCE.

 

A permanent difference usually occurs due to the fact that certain items of revenues and expenses are not allowed as deductions in the computation of taxable profit. Example of such items of expense that give rise to a permanent difference is fine and penalty expenses which are generally disallowed in the computation of the taxable profit.

Here, please note at this point that a permanent difference does NOT give rise to a deferred tax provision. So, if an item of asset or liability is not allowed for deduction in the computation of taxable profit; the implication is that the tax base of the item is zero whereas its carrying amount may not be zero. Therefore, there will be a difference which is irreversible or cannot reverse in subsequent periods. This irreversible difference is a permanent difference.

 

A timing difference, on the other hand, is the difference between accounting profit and taxable profit that occurs in one period and reverses in one or more subsequent periods. Please note that all timing differences are temporary differences but not all temporary differences are timing differences.

 

A temporary difference is the difference between the carrying amount and the tax base of an asset or liability that occurs in one period and reverses in one or more subsequent periods when the asset is recovered or liability settled.  A temporary difference may arise due to the fact that the amount or portion of an item of asset or liability allowed for deduction for tax in a period is different from the amount of the asset allocated as expense in the financial statements in the same period.

The item that most often gives rise to temporary difference is the issue of depreciation vs. capital allowance on the item of property, plant and equipment.

 

Now consider the illustration below:

 

ILLUSTRATION 2:

Leo Ltd purchased a plant on January 1, 2004 at a cost of N 800,000.00 but the tax authority, based on the current tax guideline, allows an annual capital allowance rate of 50% on the cost of the plant. Given that it is the company’s policy to depreciate its assets on a straight line basis and the plant has an estimated economic life of 4 years, what are the temporary differences for each of the period under review?

 

SOLUTION 2:

The annual depreciation amount = N 800,000.00/4 years

                                               = N 200,000.00 per annum.

The annual capital allowance amount = 50% X N 800,000.00

                                                     = N 400,000.00

The carrying amount of the plant as at December 31, 2004 will be N 600,000.00 (i.e. N 800,000.00 – N 200,000.00). While the tax base as at that date will be N 400,000.00 (i.e. N 800,000.00 – N 400,000.00).

The carrying amount of the plant as at December 31, 2005 will be N 400,000.00 (i.e. N 800,000.00 – (N 200,000.00 + N 200,000.00)). While the tax base as at that date will be N 0.00 (i.e. N 800,000.00 – (N 400,000.00 + N 400,000.00)). And so on.

The carrying amount, tax base and temporary difference of the plant as at each relevant year end is tabulated below:

ITEMS	AS AT DECEMBER 31, 2004	AS AT DECEMBER 31, 2005	AS AT DECEMBER 31, 2006	AS AT DECEMBER 31, 2007
CARRYING AMOUNT	600,000.00	400,000.00	200,000.00	0.00
TAX BASE	400,000.00	0.00	0.00	0.00
TEMPORARY DIFFERENCE	200,000.00	400,000.00	200,000.00	0.00

 

Now please note this that it is only temporary differences that give rise to a deferred tax provision.

 

At this point, we can re-frame our definition from step 2 above, on deferred tax as the income tax payable by an organization in future periods on temporary difference. This type of difference occurs just because the portion of an asset allocated as an expense (e.g. depreciation) in arriving at the accounting profit for a period is different from the portion of the tax base of the asset allocated as allowable deduction (e.g. capital allowance) in computing the taxable profit. Although, both the asset’s carrying amount and tax base are equal at initial recognition or the point of first recording its value in the books of account.

 

Therefore, it is expected that a temporary difference will reverse in one or more later or subsequent periods when the asset is realised or recovered or the liability settled.

An asset is recovered if its estimated useful life expires, or it is disposed. At that point, the sum of all its depreciations and impairments allocated yearly as expenses, and the sum of all its capital allowances deducted in computing the taxable profit will be equal. Thus, at this point, a temporary difference is reversed.

 

Step 6: Types of Temporary Difference

Well, we are not done yet with temporary difference. A temporary difference can be divided into 2 types, namely TAXABLE temporary difference (TTD) and DEDUCTIBLE temporary difference (DTD).

 

For now just know that a taxable temporary difference (TTD) is simply the temporary difference with the implication or result that income tax will be paid in future periods when the asset is recovered (as explained above) or the liability is settled (or paid). A taxable temporary difference (TTD) usually arises where the carrying amount of an asset is greater than its tax base or the carrying amount of a liability is less than its tax base.

Please note here that a deferred tax liability is measured or computed by applying the tax rate on the taxable temporary difference (TTD).

 

Deferred Tax liability = Tax Rate X Taxable Temporary Difference

 

On the other hand, a deductible temporary difference (DTD) results in income tax savings with the implication that certain sum will be deducted from the taxable profit (if any) in one or more subsequent periods when the asset is realized or the liability is settled. A deductible temporary difference (DTD) usually arises where the carrying amount of an asset is less than its tax base or the carrying amount of a liability is greater than its tax base.

Please, equally note this that a deferred tax asset is measured or computed by applying the tax rate on the deductible temporary difference (TTD).

 

Deferred Tax Asset = Tax Rate X Deductible Temporary Difference.

 

See the table below:

 

ELEMENT	PARAMETER	TYPE OF TEMPORARY DIFFERENCE	TYPE OF DIFERRED TAX
ASSET	CARRYING AMOUNT  > TAX BASE	TTD	DEFERRED TAX LIABILITY
ASSET	CARRYING  AMOUNT < TAX BASE	DTD	DEFERRED TAX ASSET
LIABILITY	CARRYING AMOUNT  > TAX BASE	DTD	DEFERRED TAX ASSET
LIABILITY	CARRYING  AMOUNT < TAX BASE	TTD	DEFERRED TAX LIABILITY

 

 

 

 

 

Then, how do we treat income tax and deferred tax in the financial statements?

To handle income tax in the financial statement you have to follow the following steps in the order listed below:

1. Calculate the current tax payable.
2. Compute the provision for deferred tax which may either be a deferred tax asset or deferred tax liability.
3. Calculate the deferred tax charge or credit, which is a movement on the deferred tax account.
4. Calculate the tax expense.
5. Charge tax expense to the income statement and disclose the deferred tax asset or liability in the statement of financial position as appropriate.
6. Determine the portion of the current tax payable that is still unpaid at year end and disclose it as a current liability as appropriate.
7. Great! You are done with accounting for income tax and the dreaded deferred tax.

Wondering how to do these? Okay let’s look at how to carry out each of these in subsequent steps of this tutorial.

 

Step 7: Computation of Current Tax Payable

Current tax payable is the income tax of a business computed for the current period on taxable profit using the prevailing tax rate. For instance, if the prevailing or ruling income tax rate in Nigeria for year 2011 is 30%, given that Nexus Limited taxable profit is N 600,000.00. Therefore, the current tax payable of Nexus Limited for year 2011 is N 180,000 (i.e. 30% X N 600,000.00).

 

A business’ taxable profit used in calculating the current tax payable is derived from the accounting profit in the Income Statement. This is computed by adjusting the accounting profit or net profit before tax for items of expenses that are disallowed and incomes that are exempted from tax based on the tax rule of the jurisdiction where the company is domiciled or incorporated.

 

With this adjustment, an adjusted profit is arrived at, but upon the deduction of capital allowance allowed in lieu of depreciation, the result becomes a taxable profit. It is on this taxable profit that the tax rate is applied to compute the current tax payable.

 

The format for this is given below:

 

Accounting Profit/Net Profit before Tax                     XX

Add: Disallowed Expenses e.g. Depreciation             XX

Less: Tax-exempted Income                                           XX

Adjusted Profit                                                                    XX

Less: Capital Allowance                                                    XX

Taxable Profit                                                                      XX

 

Therefore, Current Tax Payable = Tax Rate X Taxable Profit

 

Please tuck this information away as current tax payable is used in the computation of tax expense as you will see later in step 10 on computation of tax expense.

 

ILLUSTRATION 3:

Lexus Ltd’s accounting profit for the year ended December 31, 2014 is N 70,000.00 after deducting depreciation of N 5,000.00 and entertainment expenses of N 3,000.00 which are both disallowed for tax computation. In lieu of depreciation, the tax authority of the jurisdiction where Lexus Ltd is domiciled allows a capital allowance of N 2,500.00 for the period. Compute the taxable profit and the current tax payable at 30% tax rate for the period under consideration.

 

SOLUTION 3:

The taxable profit is calculated as follows:

	N	N
ACCOUNTING PROFIT		70,000.00
ADD:DISALLOWED EXPENSES
DEPRECIATION	5,000.00
ENTERTAINMENT EXP	3,000.00
		8,000.00
ADJUSTED PROFIT		78,000.00
LESS: CAPITAL ALLOWANCE		(2,500.00)
TAXABLE PROFIT		75,500.00
CURRENT TAX PAYABLE = 30% X 75,500.00

                                    N 22,650.00

 

Step 8: Calculation of Deferred Tax Provision

As mentioned earlier, a provision for deferred tax could either be a deferred tax asset or deferred tax liability. To understand how to determine if a deferred tax provision is either an asset or a liability you need first to understand how to calculate the amount to make as provision for deferred tax, and subsequently after, classify it either as a deferred tax asset or a deferred tax liability.

 

Then, how do we compute deferred tax provision? Or at what value is a provision for deferred tax made?

 

A provision for deferred tax is made at a value which is arrived at by applying the tax rate on the temporary difference. (Please, recall what I said about temporary difference (TD) in step 3 above). 

 

You can compute the provision for deferred tax by following these simple steps:

 

1. Prepare a schedule showing the carrying amounts and the tax bases of all your assets and liabilities for a particular period with the column headings as portrayed below:

ITEM OF ASSET/LIABILITY

CARRYING VALUE

TAX BASE

TYPE OF TEMPORARY DIFFERENCE

DIFFERENCE (In Figure)

 

2. Determine the type of temporary difference for each item of asset and liability by following the rules below:

a.    For an asset, it is a taxable temporary difference if the carrying value is greater than the tax base.

b.    For an asset, it is a deductible temporary difference if the carrying value is less than the tax base.

c.    For a liability, it is a deductible temporary difference if the carrying value is greater than the tax base.

d.    For a liability, it is a taxable temporary difference if the carrying value is less than the tax base.

3. Calculate the actual difference between the carrying amount and tax base of each item of asset and liability. Please, take care to mark as negative (-) a difference if it is a taxable temporary difference and positive (+) if it is a deductible temporary difference.
4. Sum all the differences (in figures) and determine whether the aggregate temporary difference is a taxable temporary difference (TTD) or a deductible temporary difference (DTD). If you adhere strictly to the rules in step 2 and 3 above, then the aggregate temporary difference is a deductible temporary difference if it is positive (+) and a taxable temporary difference if it is negative (-).
5. Apply the tax rate on the aggregate temporary difference in 4 above (i.e. Tax Rate X Aggregate Temporary Difference) to get the deferred tax provision.
6. Base on step 3 above your deferred tax provision is a deferred tax asset if it is positive (i.e. the aggregate temporary difference (TD) is positive) and a deferred tax liability if it is negative (i.e. the aggregate temporary difference (TD) is negative). Please, flag the antenna of your ears and note these pointers clearly!

The deferred tax provision you computed by following the above steps is the closing balance for deferred tax, and it will be either a deferred tax asset or deferred tax liability in the statement of financial position. The deferred tax provision should be classified as a non-current asset or liability.

 

If it is a deferred tax asset the accounting entries at the end of the period is:

DR: DEFERRED TAX ASSET

      CR: INCOME STATEMENT

 

ILLUSTRATION 4:

The assets and liabilities below are carried in the books of accounts of Large Limited as at December 31, 2013:

Property, plant and equipment (at cost)             N 1,000,000.00

Trade Receivables                                                N 50,000.00

Deferred Revenue                                                N 20,000.00          

The following information is also relevant:

1. Annual depreciation rate and capital allowance rate on property, plant and equipment are 20% and 25% respectively.
2. The balance of trade receivables was arrived at after deducting a provision for doubtful debt of N 5,000.00.
3. Revenue is considered for the computation of taxable profit by the tax authority in the period it is earned and cash received. So, therefore, the deferred revenue is included in the computation of the taxable profit for the period.

Required: Compute the deferred tax asset or liability as the case may be, as at December 31, 2013 given that the tax rate is 50%.      

            

SOLUTION 4:

 

ITEM	CARRYING VALUE	TAX BASE	ASSET OR LIABILITY	TYPE OF TEMPORARY DIFFERENCE	DIFFERENCE (FIGURE)
PROPERTY,PLANT&EQUIPMENT	800,000.00	750,000.00	Asset	Taxable Temporary difference	(50,000.00)
TRADE RECEIVABLES	50,000.00	55,000.00	Asset	Deductible Temporary Difference	5,000.00
DEFERRED REVENUE	20,000.00	0.00	Liability	Deductible Temporary Difference	20,000.00
TEMPORARY DIFFERENCE					(25,000.00)

Since the aggregate temporary difference is negative i.e. (N 25,000.00), this implies that the aggregate temporary difference is a taxable temporary difference.

Therefore, the DEFERRED TAX LIABILITY is equaled to N 12,500.00 (i.e. 50% X N 25,000.00).

Please note the following points about the solution:

1. The depreciation as at December 31, 2013 is N 200,000.00 (i.e. 20% X N 1,000,000.00). Therefore, the carrying amount of property, plant and equipment as at that day is N 800,000.00 (i.e. N 1,000,000.00 – N 200,000.00).
2. The capital allowance as at December 31, 2013 is N 250,000.00 (i.e. 25% X N 1,000,000.00). Therefore, the tax base (i.e. Tax Written down Value) of property, plant and equipment as at that day is N 750,000.00 (i.e. N 1,000,000.00 – N 250,000.00).
3. Since a provision of N 5,000.00 is made on trade receivables, that means that the carrying amount of trade receivables is N 50,000.00 but its tax base is N 55,000.00, since general provision on trade receivables is usually disallowed in computing taxable profit.
4. Deferred revenue of N 20,000.00 is carried in the books of Large Limited, but since in this illustration, the tax authority treats revenue in the period it is earned and cash is received, the tax base of deferred revenue will be zero.  

Step 9: Calculation of deferred tax charge or credit

Yearly, a portion of the deferred tax asset or liability will fall due as credit or as an expense charge in the current period. The portion of the deferred tax provision (either deferred tax asset or liability) that is due as either credit (to understand this just assume a credit to be a gain) or expense is determined by looking at/analysing the movement on the deferred tax provision (i.e. deferred tax asset or deferred tax liability).

 

A credit, assumed to be a gain is subtracted or deducted from the current tax payable to arrive at the tax expense. While a charge, deferred tax charge is added to the current tax payable to arrive at the tax expense.

 

For a simplify way of calculating either a deferred tax credit or charge use the method or format below:

Closing Balance of Deferred Tax Asset/Liability                              XX

Less: Opening Balance of Deferred Tax Asset/Liability                 XX

Deferred Tax Credit/Expense                                                                XX

 

Please note the following points:

1.    The deferred tax you compute at the end of a particular period (according to step 8), either a deferred tax asset or liability is the closing deferred tax provision (i.e. closing balance of either deferred tax asset or liability)

2.    Your opening balance of deferred tax is the closing balance for the prior or previous period. Where there is no prior period then your opening balance is zero. Simple, right?

3.    You should subtract deferred tax credit from your current tax payable, while deferred tax charge or expense should be added to current tax to get the tax expense.

 

Step 10: Calculation of Tax Expense

Your tax expense is the amount of tax that will be charged in the income statement.

Tax expense is computed as:

 

Tax Expense = Current Tax + Deferred Tax Charge/expense (or – Deferred Tax Credit)

 

Step 11: Income Tax Asset /Liability

There may be an income tax asset or liability in the statement of financial position at the end of the period. This asset or liability unlike deferred tax is a current asset or liability.

 

 

An income tax liability usually arises where all or a portion of the current tax payable remains unpaid at the period end. While an income tax asset can arise where more than the income tax payable for the period is paid.