LOS B requires us to:
explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis.
Deferred taxes are a result of temporary differences in recognition of expenses/revenues reported for tax purposes versus financial reporting purposes. These are a result of the difference in the reporting value as reflected by the carrying amount and as per the tax base.
For Example:Say we have an asset worth $ 10,000 and it has a depreciable life of 10 years. And the firm is providing depreciation on a straight-line basis method for the financial reporting purpose and on the double-declining balance method for tax purposes. Now the depreciation in the first year and the respective carrying value as per the financial reports and the tax reports at the end of the first year would be:
The temporary difference is the difference in the value of the carrying amount and the tax base. Therefore the temporary difference is: Further, this would result in the creation of deferred tax liability as there were lower profits reported in the tax return due to the higher value of (depreciation) expenses. This would be reversed in the future years when there would be lower profits in the financial reports. Now, also suppose that there were some unearned revenues of $ 20,000. These were reported as liabilities in the financial reports (to be utilized at a later date when the services against it are provided). However, as per the tax laws, since the cash was received, it was supposed to be reported as revenue of the current period and to be taxed accordingly. Thus the liability and their respective carrying value and tax base would be:
Thus, the temporary difference resulting due to unearned revenue would be: This would lead to the creation of deferred tax assets because there is a higher amount of tax paid in the current year, which can be expected to be reversed in future periods (when there would be actual revenues as per the accounting records and no profits as per the taxation requirements). Now suppose that there is a tax rate of 40 %, therefore the deferred tax liability as a result of the difference in the amount of depreciation would be: $1,000 × 40% = $ 400 And the amount of deferred tax asset created due to difference in the value of revenues reported would be: $20,000 × 40% = $ 8,000 Resultantly, the net deferred tax asset to be reported in the balance sheet would be: $8,000 – $ 400 = $ 7,600 |
Thus, we can conclude that a difference in the treatment of an accounting item for tax and financial reporting purpose occurs when:
a. there is a difference in the carrying value and tax base of the asset,
b. the revenue/expenses have been recognized in the income statement but not in the tax return,
c. there is a difference in the timing of recognition of revenue or expenses in the income statement and the tax return,
d. there exist carry-forward losses which can offset the future income, or
e. there exist some financial statement transactions that may not affect the tax return and may not be recognized or maybe recognized in a different period.
Deferred tax assets are created when the tax liability as per the income tax return is higher than the income tax expense as per the financial statement and vice-a-versa for the deferred tax liabilities.
Deferred tax assets are classified as non-current assets/liabilities as per the IFRS. However, they may be reported as a current or non-current item under U.S. GAAP.