Deferred Tax Application and Financial Reporting Standard

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Friday, May 28, 2021 / 09:51 AM / By CITN / Header Image Credit: Investopedia


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Introduction

Deferred tax refers to the estimated future tax consequences of transactions and events recognized in the financial statements of the current and previous periods. Deferred taxes arise when a revenue or expense item is reported on the income tax return in a year that is different from the year that the item appears on the financial statements. There are often disclosure requirements for potential liabilities and assets that are not actually recognised as assets or liabilities. The International Accounting Standard (IAS) 12 requires full provision to be made for deferred tax assets and liabilities arising from timing differences between the recognition of gains and losses in the financial statements and their recognition in tax computation.

 

The general principle that underpins the requirement is that deferred tax should be recognized as a liability or asset if the transactions or events that give the entity an obligation to pay more tax in the future or a right to pay less tax in the future have occurred by the balance sheet date.

 

International Accounting Standard (IAS) Requirement

IAS requires deferred tax to be recognized on most types of timing difference, and which includes the following attributes:

  • Accelerated Capital Allowances
  • Accruals for pension costs and other post-retirement benefits that will be deductible for tax purposes only when paid
  • Elimination of unrealized intragroup profits on consolidation
  • Unrelieved tax losses
  • Other sources of short-term timing differences

 

Prohibits the recognition of deferred tax on timing differences arising when:

  • A fixed asset is revalued without there being any commitment to sell the asset
  • The gain on sale of an asset is rolled over into replacement assets
  • The remittance of a subsidiary, associate, or joint venture's earnings would cause tax to be payable, but no commitment has been made to remittance of the earnings

 

Deferred tax assets are to be recognized to the extent that they are regarded as more likely than not that they will be recovered.

 

Objectives of Deferred Tax

  • That future tax consequences of past transactions and events are recognized as liabilities or assets in the financial statements; and
  • The financial statements disclose any other special circumstances that may affect future tax charges.

 

Permanent Differences In Deferred Tax

The permanent difference occurs as a result of differences between an entity's taxable profits and its results as stated in the financial statements that arise because certain types of income and expenditure are non-taxable or disallowable, or because certain tax charges or allowances have no corresponding amount in the financial statements.  It is the difference between financial accounting and tax accounting that is never eliminated.


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Timing Differences In Deferred Tax

Timing differences between an entity's taxable profits and its results as stated in the financial statements that arise from the inclusion of gains and losses in tax assessments in periods different from those in which they are recognized in the financial statements. Timing differences originate in one period and are capable of reversal in one or more subsequent periods:

 

Timing differences arise when:

  • tax deductions for the cost of a fixed asset are accelerated or decelerated, i.e. received before or after the cost of the fixed asset is recognized in the profit and loss account
  • pension liabilities are accrued in the financial statements but are allowed for tax purposes only when paid or contributed at a later date
  • interest charges or development costs are capitalized on the balance sheet but are treated as recurrent expenditure and allowed as incurred for tax purposes
  • intragroup profits in stock, unrealized at group level, are reversed on consolidation
  • an asset is revalued in the financial statements but the revaluation gain becomes taxable only if and when the asset is sold
  • a tax loss is not relieved against past or present taxable profits but can be carried forward to reduce future taxable profits
  • the unremitted earnings of a subsidiary and associated undertakings and joint ventures are recognized in the group results but will be subject to further taxation only if and when remitted to the parent undertaking.

 

Recognition of Deferred Tax Assets and Liabilities

  1. Deferred Tax should be recognized in respect of all timing differences that have originated but not reversed by the balance sheet date;
  2. Deferred Tax should not be recognized on permanent differences
  3. Deferred tax should be recognized when the allowances for the cost of a fixed asset is received before or after the cost of the asset is recognized in the income statement. However, where all the conditions for retaining the allowances have been met, the deferred tax should be reversed.

 

Calculating a Deferred Tax Balance - The Basics

The International Accounting Standards (IAS 12) requires a mechanistic approach to the calculation of deferred tax. The following summarises the steps necessary in calculating a deferred tax balance:

 

Step 1

Establishing the accounting base of the asset or liability

 

Step 2

Calculate the tax base of the asset or liability (if there is no difference between tax and accounting base, no deferred tax is required. Otherwise go to step 3)

 

Step 3

Identify and calculate any exempt temporary differences

 

Step 4

Identify the relevant tax rate and apply this to calculate deferred tax

 

Step 5

Calculate the amount of any deferred tax asset that can be recognized

 

Step 6

Determine whether to offset deferred tax assets and liabilities.


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