Complete Guide to Deferred Taxes – Assets & Liabilities

Updated on April 3, 2024
Article byDheeraj Vaidya, CFA, FRM

deferred taxes

To start with what are deferred taxes, let’s understand it primarily in a layman’s term. The dictionary meaning of the word ‘deferred’ is delayed or postponed. To defer the taxes is ‘deferred taxation’. It is the tax effect of timing differences. To classify, there are two kinds of Deferred Taxes-

  1. Deferred Tax Asset
  2. Deferred Tax Liability

In India, the accounting standards are prescribed by the Institute of Chartered Accountants of India (ICAI). The accounting standard specifically designed for the treatment under Deferred Taxation is – AS 22 “Accounting for Taxes on Income”.

The Standard focuses on one of the fundamental principles of accounting i.e. Matching Concept.

To take it further, we need to know some basic definitions used in the context of deferred taxes.

  1. Current Tax-

Current Tax is the amount of tax which is payable on income of the current financial year.

  1. Deferred Tax-

Deferred Tax is the tax effect of timing differences.

Why does this difference arises? We all are aware of the concept called ‘accrual basis’, yes you’re right even tax can be calculated on accrual basis. The difference between the tax expenses calculated on accrual basis and the current tax expenses are called as deferred taxes.

  1. Tax Expenses-

This can be understood through a simple equation-

Total tax expenses= Current Tax Expense +Deferred Tax Expense

There are two kinds of profit-

  1. Accounting Profit
  2. Tax Profit

 

What is the difference between them? Some things are included in profit as per accounting principles and not as per income tax rules & vice versa. This creates difference in profits and resultant differences in the taxes.

The reasons for such differences are of two kinds-

  1. Timing Difference-

These are the kind of differences which arise in one period and get reversed in subsequent periods. The timing differences have to be accounted for in the books of accounts.

  1. Permanent Difference-

As the name goes these are permanent in nature, they do not get reversed at any point of time. No accounting treatment is to be done for permanent differences.

Let us first understand the accounting entries for deferred taxes-

Accounting Entries-


  1. In case a deferred tax asset is to be created-

Deferred Tax Asset A/C   Dr.

To Deferred Tax Income A/C

  1. In case a deferred tax liability is to be created-

Deferred Tax Expense A/C  Dr.

To Deferred Tax Liability A/C

  1. Transfer of Deferred Tax Income to Profit and Loss Account-

Deferred Tax Income A/C  Dr.

To Profit and Loss Account A/C

  1. Transfer of Deferred Tax Expense to Profit & Loss Account-

Profit and Loss A/C   Dr.

To Deferred Tax Expense A/C

Now let us understand the various reasons for arisal of deferred taxation-

Particulars Opening Balance Closing Balance
Fixed Assets-
WDV of assets as per Income Tax Act,1961
WDV of assets as per books of accounts
Statutory Payments-
Disallowance under Section 43B of Income Tax Act,1961
Employee Benefits-
1.       Gratuity
Provision for Gratuity
Gratuity asset/defined benefit asset on gratuity
2.       Leave Encashment
Provision for leave encashment
Defined Benefit Asset on Leave Encashment
3.       Bonus or Commission
Provision for bonus
Advance bonus/commission for the services rendered
4.       Provident and other funds-
Provision for Provident fund and other funds
Advance contribution to Provident Fund and others
Bad debts-
Provision for bad and doubtful debts
Other provisions (can be of any nature)
Losses and depreciation
Business Losses
Speculative business losses
Long Term Capital Gain Losses
Short Term Capital Losses
Loss from House Property
Loss from horse racing
Unabsorbed Depreciation
Preliminary, VRS, Amalgamation Expenses    
Expenses incurred
Less : Deduction as per IT Act
Expenses on which TDS is not deducted/paid  
Expenses which were disallowed in previous year but not allowable after payment of taxes  
Any other expenses which are not covered either in Income Tax Act or books of account
Any other timing difference

 

NOTE : Deferred Taxes are not created for permanent differences.

As written in the above paragraphs, once again it is very important to understand the basic funda behind deferred taxation is the treatment of same item differently  in Income Tax Act and Companies Act under which the books of accounts are maintained.

Deferred tax is tax effect of timing difference-

Accounting income is in excess of tax income Tax on accounting income is more whereas tax payable is less as per Income Tax law for the period Create deferred tax liability by crediting to deferred tax and debit to profit and loss account
Accounting income is less than the tax income Tax on accounting income is less whereas tax payable is more as per Income Tax Law Create deferred tax asset by debiting deferred tax.
There is income as per income tax but loss as per accounts. Tax on accounting loss is nil but there is liability to pay tax Create deferred tax assets by debiting deferred tax (subject to recoverability/adjustments from future income).
Accounting profit but loss as per Income Tax law. However MAT is payable. Tax on accounting profit but tax as per tax law is nil. Carry forward of loss is allowed. Create deferred tax liability for the difference.

Prudence for Recognizing Deferred Tax Asset-


This is another very important concept in context of Deferred Taxes. Deferred tax asset/liability should be measured for all timing differences. But deferred tax asset should be recognized and carried forward only to the extent it is *virtually certain that there will be sufficient future income to recover such deferred tax asset. In case there is no future sufficient income, deferred tax asset should be recognized only to the such asset can be recovered by way of tax saving.

In the case of tax free companies, no deferred tax liability is recognized in respect of timing differences that originate and reverse in the tax holiday period .Deferred Tax Asset or Deferred Tax Liability is created in respect of timing differences that originate in a tax holiday period but are expected to reverse after a tax holiday period.

Virtual certainty refers to the extent of certainty which for all practical purposes can be considered certain. It should be supported by a convincing evidence.

There are three stages under Deferred Taxation-

Stage 1– Points to be considered for recognition of deferred tax

Stage 2– Measurement of Tax Expense

Stage 3– Periodical Review of Deferred Tax Assets or Deferred Tax Liabilities

Steps in recognition of deferred taxes-

  1. Ascertain and identify all items of timing differences
  2. Classify it as Deferred Tax Asset or Deferred Tax Liability
  3. Quantify the Deferred Tax Asset or the Deferred Tax Liability
  4. See to it whether it is Originating Timing Difference or Reversal of Timing Difference. The Originating Timing Difference is the once which arises for the first time and the Reversal of Timing Difference is the one which arose during past years and is now getting reversed.
  5. The fact that it is Originating Timing Difference or Reversal of Timing Difference decides it treatment and presentation in books of accounts.
  6. Where tax liability is postponed, it amounts to Deferred Tax Liability. In that case you have to pass the following entry-

Deferred Tax Expenses A/C Dr

To Deferred Tax Liability A/C

  1. Where tax liability is paid in advance, it amounts to Deferred Tax Asset. In that case, you have to pass the following entry-

Deferred Tax Asset A/C DR

To Deferred Tax Income A/C

Now let us understand the presentation of deferred tax asset/ deferred tax liability in the books of accounts-

  1. It is not necessary that the company faces same scenario every year i.e. if in one particular year, there is deferred tax asset that does not mean that every year there is going to be deferred tax asset only, the deferred tax liability may arise in subsequent years.
  2. The deferred tax liability(net) or the deferred tax asset(net) is shown on the face of the balance sheet or statement of affairs.
  3. The question arises how does this netting off takes place and the rules regarding such netting off-
  4. Deferred Tax items can be set off only and only if two conditions are met. First is the legal right and the second is common applicable tax law for both the items.
  5. It should be ensured that the breakup of amounts relating to netting off items is disclosed in notes to accounts

Now let us understand the concept of deferred taxes with some simple illustrations-

  • Illustration 1

Calculate the deferred tax asset/liability from the following data:

Accounting Profit                            Rs. 2000,000

Book Profit as per MAT*                 Rs. 1800,000

Profit as per Income Tax Act         Rs.   200,000

Tax rate                                                   30%

MAT rate                                              7.50%

Solution:

Tax as per accounting profit will be 600,000 i.e. 2000000*30%

Tax as per income tax profit  will be  60,000 i.e. 200000*30%

Tax as per MAT will be 135000 i.e. 1800000*7.5%

Now,

Tax Expense= Current Tax + Deferred Tax

600000=60000+Deferred Tax

So, Deferred Tax=540,000

Amount of Tax to be debited in P&L A/C is –

Current Tax + Deferred Tax + Excess of MAT over current tax

=60000+540000+75000

=675000

*MAT is Minimum Alternative Tax. If the tax payable of any company is below 18.5% of its total income, then that company is required to pay atleast i.e. minimum 18.5% of tax on its total income. This is a measure used to collect atleast a prescribed amount of tax from companies having profits.

  • Illustration 2

Identify whether the following items constitute permanent difference or timing difference-

  1. Statutory dues not paid till due date of filing return, but accounted for in the books
  2. Difference in depreciation rates as per Companies Act and Income Tax Act
  3. Donations
  4. Penalties
  5. Revaluation Reserve
  6. Unabsorbed losses and depreciation

Solution:

Particulars Nature of Difference Deferred Tax Asset/ Deferred Tax Liability
Statutory dues not paid till due date of filing return, but accounted for in the books Timing

 

Deferred Tax Asset
Difference in depreciation rates as per Companies Act and Income Tax Act Timing Deferred Tax Asset/ Deferred Tax Liability (depends on case to case)
Donation Permanent Neither Deferred Tax Asset nor Deferred Tax Liability
Penalties Permanent Neither Deferred Tax Asset nor Deferred Tax Liability
Revaluation Reserve* Permanent Neither Deferred Tax Asset nor Deferred Tax Liability
Unabsorbed losses and depreciation Timing Deferred Tax Asset

 

*There is no concept of revaluation reserve in Income Tax Laws.

  • Illustration 3

Now let us understand the computation of deferred taxation.

Suppose,

Preliminary Expenses as per books is 400000

Preliminary Expenses as per Income Tax Act is 250000

Allowed period for writing off the preliminary expenses as per books is 5 years

Allowed period for writing off the preliminary expenses as per Income Tax Act is 10 years.

COMPUTATION


Year Charge as per P&L A/C Charge as per Income Tax Timing Difference Tax effect on timing differences Deferred Tax
1 0.50 0.25 0.25 -0.0875 0.0875
2 0.50 0.25 0.25 -0.0875 0.1750
3 0.50 0.25 0.25 -0.0875 0.2625
4 0.50 0.25 0.25 -0.0875 0.3500
5 0.50 0.25 0.25 -0.0875 0.4375
6 0.25 -0.25 0.0875 0.3500
7 0.25 -0.25 0.0875 0.2625
8 0.25 -0.25 0.0875 0.1750
9 0.25 -0.25 0.0875 0.0875
10 0.25 -0.25 0.0875 0
2.50 2.50

This is all about deferred taxation. This is not a topic which can be understood at one stroke. It requires conceptual understanding of basically two laws- one is Companies Act, 2013 and the other is Income Tax Act, 1961. It requires constant reading, understanding and practice to get pro in this topic.

Also, it requires an in depth knowledge about the Accounting Standards issued by Institute of Chartered Accountants of India. Not every company, firm, etc comes under the gamut of AS-22 i.e. Accounting for Taxes on Income. The Accounting Standards are applicable to enterprises as per their levels  i. e.  Level I, Level II and Level III. Some Accounting Standards are applicable to all the enterprises while the applicability of some accounting standards is restricted to some entities only.

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