Unlocking the Mystery of Deferred Tax: A Comprehensive Guide

Navigating the complexities of deferred tax can often feel like decoding a foreign language for many business leaders. Yet, understanding this intricate aspect of financial management is crucial for making informed decisions and presenting a true and fair view of financial statements. So, let’s get started!

?What is Deferred Tax?

?Deferred tax refers to the tax effect resulting from timing differences between the accounting profits and taxable profits of a business. These differences arise due to the different methodologies used to calculate profits under International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP) and tax laws. In simpler terms, deferred tax means the tax that has been deferred and will be settled at a future date.

Example: Company A contributes to a defined contribution pension scheme. At the year-end, Company A has recognized an accrual of $5,000. In the country where Company A is domiciled, contributions to the scheme are taxed on a cash basis. Therefore, the tax base of this liability is nil, creating a temporary difference of $5,000. A tax deduction will be available in the future when these contributions are paid to the scheme, making this a deductible temporary difference.

?Importance of Understanding Deferred Tax:

?1. Accurate Financial Reporting: This ensures a complete and accurate picture of a company's financial position by recognizing future tax effects of current transactions.

2. Tax Planning: It facilitates effective tax planning and management by understanding the timing of tax payments.

3. Stakeholder Confidence: It enhances transparency and builds confidence among investors and stakeholders by demonstrating a comprehensive approach to financial and tax management.

?

Differences Leading to Deferred Tax

Accounting profits are determined in accordance with IFRS or GAAP, whereas taxable profits are calculated based on country-specific Tax laws. The differing methodologies employed to calculate profits under IFRS/GAAP and tax laws result in variations, leading to distinctions such as permanent and temporary differences.

Permanent Differences - Permanent differences are items that are included in accounting profit but never in taxable profit, or vice versa. These do not create deferred tax since they never reverse. An example is fines and penalties, which are expenses in accounting but not deductible for tax purposes.

?Temporary Differences- Temporary differences are items that will reverse in the future and impact both current and future periods, thereby creating deferred tax assets or liabilities. These differences fundamentally represent timing variations regarding the recognition of transactions in IFRS/GAAP financial statements and for tax purposes. Examples include loss carryforwards and depreciation differences.

?

Classification of Deferred Tax

?1. Deferred Tax Asset (DTA): It refers to temporary differences that create future tax savings or reduced tax liabilities for the company. Deferred tax assets are recognized for all deductible temporary differences, to the extent that it is probable future taxable profit will be available against which these differences can be utilised.

Scenarios Leading to the Recognition of Deferred Tax Assets:

• Provisions deductible from future taxable income on a cash basis.
• Recognized impairment losses for assets other than goodwill, not affecting the tax base of related assets.

2. Deferred Tax Liability (DTL): It represents a future tax obligation that a company is expected to pay due to temporary differences between its accounting earnings and taxable income.

Scenarios Leading to Recognition of Deferred Tax Liabilities:

• Accelerated tax depreciation of a fixed asset compared to accounting depreciation.
• Capitalised expenditure for accounting, but treated as a one-off expense for tax.
• Upward revaluation of assets ignored for taxation.

Accounting for Deferred Tax

1. Initial Recognition and Measurement - The initial recognition involves identifying and measuring the temporary differences at the reporting date. This includes determining the tax bases of assets and liabilities and calculating the tax rates expected to apply when the temporary differences reverse.
2. Subsequent Measurement - Deferred tax assets and liabilities are subsequently measured at the end of each reporting period. This involves reassessing the carrying amounts, tax bases, and the tax rates applied. Changes in tax rates or tax laws may also impact the measurement of deferred tax.
3. Balance Sheet Presentation - Deferred tax assets and liabilities are presented on the balance sheet as non-current items. They are often netted against each other if they relate to the same tax jurisdiction and entity.
4. Income Statement Presentation - Deferred tax effects are recognized in the income statement, impacting the tax expense for the period. The presentation involves distinguishing between current and deferred tax expenses or benefits.

Though Deferred tax calculations can be complex, involving numerous variables and assumptions. It plays a key role in accurate financial reporting, helping businesses align accounting practices with tax obligations. By understanding and managing deferred tax, companies can improve financial transparency and ensure compliance with evolving regulations. Regularly reviewing your deferred tax position is essential for long-term financial planning and stability.