Deferred tax

Modern accounting standards typically require that a company provides for deferred tax in accordance with either the temporary difference or timing differenceapproach. Where a deferred tax liability or asset is recognised, the liability or asset should reduce over time (subject to new differences arising) as the temporary or timing difference reverses.

Under International Financial Reporting Standards, deferred tax should be accounted for using the principles in IAS 12: Income Taxes, which is similar (but not identical) to SFAS 109 under US GAAP. Both these accounting standards require a temporary difference approach.

Temporary differences

Temporary difference are differences between the carrying amount of an asset or liability recognized in the statements of financial position and the amount attributed to that asset or liability for tax; or

deductible temporary differences, which are temporary differences that will result in deductible amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.^[1]

Illustrated example

The basic principle of accounting for deferred tax under a temporary difference approach can be illustrated using a common example in which a company has fixed assets which qualify for tax depreciation.

The following example assumes that a company purchases an asset for $1,000 which is depreciated for accounting purposes on a straight-line basis of five years of $200/year. The company claims tax depreciation of 25% per year. The applicable rate of corporate income tax is assumed to be 35%. And then subtract the net value.

	Purchase	Year 1	Year 2	Year 3	Year 4
Accounting value	$1,000	$800	$600	$400	$200
Tax value	$1,000	$750	$563	$422	$316
Taxable/(deductible) temporary difference	$0	$50	$37	$(22)	$(116)
Deferred tax liability/(asset) at 35%	$0	$18	$13	$(8)	$(41)

As the tax value, or tax base, is lower than the accounting value, or book value, in years 1 and 2, the company should recognize a deferred tax liability. This also reflects the fact that the company has claimed tax depreciation in excess of the expense for accounting depreciation recorded in its accounts, whereas in the future the company should claim less tax depreciation in total than accounting depreciation in its accounts.

In years 3 and 4, the tax value exceeds the accounting value, therefore the company should recognise a deferred tax asset (subject to it having sufficient forecast profits so that it is able to utilise future tax deductions). This reflects the fact that the company expects to be able to claim tax depreciation in the future in excess of accounting depreciation.

Timing differences

In many cases the deferred tax outcome will be similar for a temporary difference or timing difference approach. However, differences can arise such as in relation to revaluation of fixed assets qualifying for tax depreciation, which gives rise to a deferred tax asset under a balance sheet approach, but in general should have no impact under a timing difference approach.

Justification for deferred tax accounting

Deferred tax is relevant to the matching principle.

Deferred tax liabilities

Deferred tax liabilities generally arise where tax relief is provided in advance of an accounting expense/unpaid liabilities, or income is accrued but not taxed until received. Examples of such situations include:

Company takes accelerated depreciation per tax laws, in excess of depreciation allowable by financial accounting standards

Deferred tax assets

Deferred tax assets generally arise where tax relief is provided after an expense is deducted for accounting purposes.Examples of such situations include:

a company may accrue an accounting expense in relation to a provision such as bad debts, but tax relief may not be obtained until the provision is utilized
a company may incur tax losses and be able to "carry forward" losses to reduce taxable income in future years..

An asset on a company's balance sheet that may be used to reduce any subsequent period's income tax expense. Deferred tax assets can arise due to net loss carryovers, which are only recorded as assets if it is deemed more likely than not that the asset will