Deferred Tax Asset
Temporary differences are either taxable or deductible. Taxable temporary differences are those which result in a higher taxable income in future period and deductible temporary differences are those which result in a lower taxable income in future. A deferred tax asset represents the deductible temporary differences.
A deferred tax can also arise in event of an operating loss that can be carried forward to future periods for offsetting against future period taxable income.
For example, Company ABC Limited has EBT $30 m, ABC Limited received additional $2 m rental payment in current financial year xx00 that is paid in advance for next financial year. For tax purpose, the whole $32 million received in current period is taxable income. We assumed tax rate is 30% calculated in cash basis that is common practise from IRS/ATO/IRD/State Tax department. However, businesses operate on accrual basis (invoice basis) accounting method, who recognised $30 million EBT, the $2 million set in financial position (balance sheet) liability side. It created temporary different between company profit loss tax expense account and tax payable liability account paid to tax department.
Company tax expense in year xx00: $30 m x 30% = $9 m
Tax charged by tax department in year xx00: $32 m x 30% = $9.6 m
The excess tax paid in current year xx00 of $0.6 m must be moved to next financial year.
Dr Current tax expense in P/L year xx00 $9,000,000
Cr Tax payable in B/S year xx00 $9,600,000
Above journal is imbalanced, therefore correct journals are following at xx00 year end
Dr Current tax expensed in P/L year xx00 $9,000,000
Dr Deferred tax asset in B/S $600,000
Cr Tax payable in B/S year xx00 $9,600,000
In following financial year xx01, assume Company ABC Limited has EBT $36 m that included the $2 m rental receive in previous financial year xx00. Tax department recognised income on cash basis that is $34 m.
Company tax expense in year xx01: $36 m x 30% = $10.8 m
Tax charged by tax department in year xx01: $34 m x 30% = $10.2 m
The different had been paid in pervious year xx00.
Journal records are following
Dr Current tax expense in P/L year xx01 $10,800,000
Cr Tax payable in B/S year xx01 $10,200,000
Cr Deferred tax asset in B/S $600,000
Above journal we recognized a deferred tax asset $600,000 at the end of the first year xx00 which can be now offset at the correct income tax expense in year xx01.
Golden Rule Summary: Deferred Tax Asset recognised when tax department charged more tax payment than current year profit loss tax expense account. We use this Deferred Tax Asset account balance between current tax expense account in profit loss and tax payable liability account. It is purely accounting mechanism. Eventually, deferred tax asset will be offset in further period, when asset sold sale recognised time issue eliminated.
Deferred Tax Liability
A deferred tax liability is a liability recognized when tax paid in current period is lower that tax that would be payable if calculated under accrual basis. It arises when tax accounting rules defer recognition of income or advance recognition of an expense resulting in a decrease in taxable income in current period that would reverse in future.
Financial statements are prepared in accordance with accounting standards but income tax payable is worked out based on income tax rules of the tax authorities such as IRS/ATO/IRD/State Tax department.
There exist many differences in the accounting treatment and tax rules. First, there are income items which are exempt from tax such as interest on municipal bonds; Second, there are expense items which are not allowed as deduction such as fines; These two differences are called permanent differences. These are the differences between accounting and tax rules which will always exist. Third and the most important difference is the timing difference in recognition of income or expense items.
For example, Company ABC recognised depreciated expense on machine XYZ $5 m at year end xx02, and will continue depreciate anther $5 m at year end xx03. Company Limited has EBTDA $40 m, less depreciate expense $5 m, income is $35 m at year end xx02.
Tax department ruled out all high-tech equipment specified listed machine XYZ must be depreciated at $10 m due to high tech nature. That depreciated machine XYZ total book value in one year.
We assumed tax rate is 30% calculated in cash basis that is common practise from IRS/ATO/IRD/State Tax department. However, Company ABC Limited recognised $35 million income in xx02. Tax department says income is $30 million. It created temporary different between company profit loss tax expense account and tax payable liability account paid to tax department.
Company tax expense in year xx02: $35 m x 30% = $10.5 m
Tax charged by tax department in year xx02: $30 m x 30% = $9 m
The underpaid tax in current year xx02 of $1.5 m must be moved to next financial year.
Dr Current tax expense in P/L year xx02 $10,500,000
Cr Tax payable in B/S year xx02 $9,000,000
Above journal is imbalanced, therefore correct journals are following at xx02 year end
Dr Current tax expense in P/L year xx02 $10,500,000
Cr Tax payable in B/S year xx02 $9,000,000
Cr Deferred tax liability in B/S $1,500,000
In following financial year xx03, assume Company ABC Limited has EBTDA $35 m, which continue depreciate $5 m bought from year xx02. Company ABC Limited recognised income $30 m at year end xx03. Tax department says income is $35 m, due to all high-tech equipment specified listed machine XYZ must be depreciated at $10 m due to high tech nature. There is no more depreciation on machine XYZ in xx03 from tax department perspective.
Let’s calculate tax
Company tax expense in year xx03: $30 m x 30% = $9 m
Tax charged by tax department in year xx03: $35 m x 30% = $10.5 m
The different had been retained deferred tax liability in pervious year xx02.
Journal records are following
Dr Current tax expense in P/L year xx03 $9,000,000
Dr Deferred tax liability in B/S $1,500,000
Cr Tax payable in B/S year xx03 $10,500,000
Above journal we recognized a deferred tax liability $1,500,000 at the end of year xx02 which can be now offset at the correct income tax expense in year xx03.
Golden Rule Summary: Deferred Tax Liability recognised when tax department charged less tax payment than current year profit loss tax expense account. We use this Deferred Tax Liability account balance between current tax expense account in profit loss and tax payable liability account. It is purely accounting mechanism. Eventually, deferred tax liability will be offset in further period, when asset sold sale recognised time issue eliminated.