Demystifying Deferred Tax: A Thought Leadership Article by Dawgen Global

Deferred tax is often viewed as a complex concept, misunderstood by many professionals and businesses alike. Contrary to popular belief, deferred tax is not an actual tax payment but an accrual for tax. It functions similarly to other accruals or provisions by aligning the tax effect of transactions with the period in which they occur. This alignment adheres to the accrual principle, ensuring that expenses and income are recognized in the appropriate periods.

Understanding Deferred Tax

Deferred tax arises from the temporary differences between the carrying amount of an asset or liability and its tax base. According to IAS 12 (Income Taxes), deferred tax represents the income tax payable or recoverable in future periods in respect of:

1. Temporary differences
2. Unused tax losses
3. Unused tax credits

The calculation of deferred tax involves:

• Temporary difference: The difference between the carrying amount of an asset or liability and its tax base.
• Income tax rate: Applied to the temporary difference to calculate the deferred tax asset or liability.

Taxable and Deductible Temporary Differences

• Taxable Temporary Differences: When the carrying amount of an asset exceeds its tax base, a deferred tax liability arises.
• Deductible Temporary Differences: When the carrying amount of an asset is less than its tax base, a deferred tax asset arises.

This concept applies equally to liabilities, which can be viewed as items with negative carrying amounts. For instance, a provision of $500,000 has a carrying amount of -500,000.

Practical Example: Interest Revenue Accrual

Consider a company that lent $100,000 to its subsidiary on January 1, 20X2, at an interest rate of 3%, with repayment due on January 1, 20X3. The company recognizes interest revenue of $3,000 in 20X2 but pays taxes on this revenue only in 20X3 when the cash is received. Here’s how the deferred tax is handled:

Journal Entries

• In 20X2: Recognizing interest accrual revenue:
  • Debit: Deferred interest revenue: $3,000
  • Credit: P/L – Interest revenue: $ -3,000
• In 20X3: Recognizing tax effects:
  • Debit: P/L Current income tax (20% of 3,000): $600
  • Credit: Bank account or current income tax liability: -$600

To align the tax effect with the period of the transaction, a deferred tax liability (DTL) of 600 CU is recognized in 20X2:

• Debit: P/L – Deferred tax expense: $600
• Credit: Deferred tax liability: -$600

In 20X3, the DTL is reversed:

• Debit: Deferred tax liability: $600
• Credit: P/L – Deferred tax income: -$600

This ensures the tax effect aligns with the interest revenue recognized in 20X2.

Determining the Tax Base

The tax base of an asset or liability is defined as the amount attributable to it for tax purposes. This is crucial for calculating deferred tax.

Tax Base of Assets

The tax base of an asset is the amount deductible against future taxable benefits. For example:

• Capitalized Software Development:
  • Cost: $30,000
  • Tax deduction when paid: $30,000
  • Remaining deductible amount: 0 $ (Tax base = 0)
• Depreciated Car:
  • Cost: $20,000
  • Tax deductions (25% annually for two years): $10,000
  • Remaining deductible amount: $10,000 CU (Tax base = $10,000 )

Tax Base of Liabilities

The tax base of a liability is its carrying amount minus the amount deductible for tax purposes in the future. For example:

• Provision for Warranty Repairs:
  • Carrying amount: -$500,000
  • Deductible amount in the future: -$500,000
  • Tax base: $0

Conclusion

Deferred tax plays a pivotal role in financial reporting, ensuring that the tax effects of transactions are aligned with the periods in which they occur. By understanding the principles outlined in IAS 12, businesses can improve the accuracy and relevance of their financial statements. Recognizing deferred tax as an accrual rather than a tax payment demystifies its purpose and fosters better financial management.

At Dawgen Global, we help businesses navigate complex accounting standards like IAS 12. Let’s have a conversation about how we can assist you in making smarter and more effective financial decisions.

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