Meaning of Deferred Taxes
Deferred tax is a form of tax which has been Reduced in advance and can be subsequently carried forward or that will be payable in the future. The difference arising between accounting income and taxable income is known as deferred taxes. Tax effect of deferred taxes is considered only if they arise due to temporary differences. IAS 12 requires that a deferred tax liability or asset is recorded in respect of all taxable temporary differences that exist at the year-end.
Objective of Deferred Taxes
A tax on income is one of the most important items in an entity’s financial statement. Keeping the matching concept in mind, taxes on income accrue during the same period as revenue and expenses. However, in many cases, taxable income may differ from accounting income. These differences must be accounted for to give a fair view of the financial statements to the stakeholders and hence recognition criteria and accounting entries have been prescribed in IAS 12 for deferred taxes. These differences may arise due to two main reasons:
- Difference in revenue and expenses reflecting in P&L account considered as revenue, expense or deduction for tax purposes.
- Difference in amounts recorded as revenue or expenses in P&L account and that considered for taxation purposes. e.g., Rate of Depreciation differs as per Income Tax Act and Companies Act.
Important Terms related to Deferred Taxes
Listed below are a few important definitions necessary to understand the concept of deferred taxes:
- Accounting income is the net profit before tax for a period, as reported in the profit and loss statement.
- Taxable income is the income on which income tax is payable, computed by applying provisions of the Income Tax Act, 1961 & Rules.
- Current Tax: Amount of Income tax determined to be paid / recoverable during a period.
- Tax Expense: Aggregate of Current tax & Deferred tax charged to P&L account
- Tax Savings: Aggregate of Current tax & Deferred tax credited to P&L account
COMPARISON BETWEEN ACCOUNTING PROFIT AND TAXABLE PROFIT
| BASIS FOR COMPARISON | ACCOUNTING PROFIT | TAXABLE PROFIT |
| Meaning | The term accounting profit refers the company’s income obtained after reducing total expenses from total revenues. | The term taxable profit refers to the profit of the business which is taxable as per income tax rules. |
| Basis | Accounting Standard | Income Tax Act 1961 |
| Year | Financial Year | Income of Previous Year is Taxable in Assessment Year. |
| Objective | To know the profitability and performance of the entity. To know the taxability of the entity. |
To know the taxability of the entity. |
| Audit | Financial Audit | Tax Audit |
Permanent and Temporary Differences
Difference between taxable income and accounting income can be classified into Permanent difference and temporary difference.
- Timing Difference
Timing differences are those differences between accounting income and taxable income which can be reversed in one or more subsequent periods. For example, Depreciation allowed as per WDV method for computing taxable income and as per SLM method for computing accounting income.
2. Permanent Difference
Permanent differences are those differences between accounting income and taxable income which cannot be reversed any subsequent period. For example, Donation paid in cash is disallowed in computing taxable income whereas it is allowed as expenditure while computing accounting income.
There can be differences between accounting income and taxable income because of the following reasons:
1. Expenses debited in profit and loss statement, but disallowed as per Income Tax Act 1961, while computing taxable income
- Provision for Bad/doubtful debts allowed while computing accounting income, but disallowed while computing taxable income
- Charging depreciation using different rates as per Companies Act 2013 and Income Tax Act 1961
- Any income recognized on an accrual basis in profit and loss statement but recognized on receipt basis in subsequent period for computing taxable income.
In order to account for these kinds of differences, AS 22 needs to be applied.
When to apply AS 22 Accounting for Taxes on Income
AS 22 needs to be applied when there are timing differences between taxable income and accounting income. If taxable income is greater than accounting income, then it will result in deferred tax asset. And if accounting income is greater than taxable income, then it will result in deferred tax liability.
When the difference is resulting in deferred tax asset, then it should be recognized only when there is a reasonable certainty of its realization. The recognition of deferred tax asset should be to the extent of the reasonable certainty of the expected realization. The reasonable certainty can be determined by making the realistic estimates of future profits based on the examination of profits and loss statement of earlier periods.
Say, an entity has unabsorbed depreciation or carry forward of losses. In such a case, deferred tax asset should be recognized to the extent there is a virtual certainty supported by convincing evidence. Virtual certainty is a matter of judgment of convincing evidence, which should be available in a concrete form at a particular date.
How to apply AS 22 Accounting for Taxes on Income
The application of AS 22 can be explained with the help of examples:
Example of timing difference:
| Particulars | Year 1 | Year 2 | Year 3 |
| Profit before tax (A) | 100,000 | 200,000 | 180,000 |
| Depreciation as per Companies Act (B) | 25,000 | 25,000 | 25,000 |
| Accounting income (A-B) | 75,000 | 175,000 | 125,000 |
| Depreciation as per Income tax Act (C) | 50,000 | 0 | 10,000 |
| Taxable income (A-C) | 50,000 | 200,000 | 170,000 |
| Timing difference (D) | 25,000 | -25,000 | -15,000 |
| Current tax @ 30% | 15,000 | 60,000 | 51,000 |
| Deferred tax (D * 30%) | 7,500 | -7,500 | -4,500 |
| Total tax expense | 22,500 | 52,500 | 46,500 |
| Profit after tax | 52,500 | 122,500 | 78,500 |
Deferred tax Computation
| Particulars | Year 1 | Year 2 | Year 3 |
| Opening balance of timing difference | 0 | 25,000 | 0 |
| Addition | 25,000 | 0 | 15,000 |
| Deletion | 0 | 25,000 | 0 |
| Closing balance of timing difference | 25,000 | 0 | 15,000 |
| Deferred tax @ 30% | 7,500 | 7,500 | 4,500 |
| DTA/DTL | Creation of DTL | Reversal of DTL | Creation of DTA |
| Journal Entry | P&L A/c Dr To DTL |
DTL Dr To P&L A/c |
DTA Dr To P&L A/c |
Deferred Tax Asset & Deferred Tax Liability
Deferred Tax Asset (DTA)
Where the book profits in a year are less than taxable income, the excess tax paid today is known as Deferred Tax Asset. DTA is recognised only if there is future virtual certainty i.e. it is realized only when sufficient future taxable income can be reliably estimated.
Let us understand this with an example:
M/s Om Ltd which manufactures cars. The company assumes that the probability of a car being sent for warranty repairs is 1%. If M/s Om Ltd.’s revenue for financial year 2018 is Rs.22,00,000, then the following difference arises in the accounting income and taxable income.
Income as per Books of Account
| Revenue | Rs 22,00,000 |
| Warranty Expense | Rs 22,000 |
| Income | Rs 21,78,000 |
| Tax Payable (Rate of Tax=30%) | Rs 6,53,400 |
Taxable Income
| Revenue | Rs 22,00,000 |
| Warranty Expense | Rs 0 |
| Taxable Income | Rs 22,00,000 |
| Tax Payable (Rate of Tax=30%) | Rs 6,60,000 |
The deferred tax asset based on the example above would be calculated as follows:
(Rs 6,60,000 – Rs 6,53,400) = Rs. 6,600
Deferred Tax Liability (DTL)
Where the book profits in a year are more than taxable income, the deficit tax paid today is known as Deferred Tax Liability (DTL). The provision of virtual certainty is not applicable while recording DTL.
Let us take an example of the same company M/s OM Ltd which manufactures cars. Assuming that a fixed asset costs Rs 60,000 will last for 3 years. They will account Rs 20,000 p.a. as depreciation in P&L accounts by using SLM as the method of calculating depreciation. However as per the taxation laws depreciation is calculated differently.
| Depreciation | Year 1 | Year 2 | Year 3 |
| As per Books of Accounts | 20,000 | 20,000 | 20,000 |
| As per Tax Laws | 30,000 | 20,000 | 10,000 |
| 10,000 | – | 10,000 | |
| Tax at the rate 30% | (3,000) | – | 3,000 |
| DTA/(DTL) | DTL | – | DTA |
As shown above, the difference between the tax that the company should have paid on the basis of accounting and the tax that it actually paid shall amount to a deferred tax liability of Rs 3,000.
Effect on Minimum Alternate Tax (MAT)
As per section 115JB of the Income Tax Act, Minimum Alternate Tax(MAT) is required to be paid by a company if the tax payable calculated as per the provisions of the income tax act is less than 18.5% of the book profits. Book profit for this purpose is to be calculated as per the provisions of section 115JB.
There are controversies if deferred tax liability debited to P&L should be added to the book profit for MAT calculations. There are contrary views regarding this issue by Kolkata Tribunal in Balrampur Chini and Chennai Tribunal in Prime Textiles Ltd case.
Presentation of Deferred Taxes in Financial Statements
Profit and Loss Account
Journal entries:
1. Profit and loss account Dr xxx
To Current tax Account xxx
(Being provision for current tax made)
- Profit and loss account Dr xxx
To Deferred Tax Account xxx
(Being Deferred tax liability created)
Balance Sheet
Deferred tax asset and deferred tax liability should be netted off and should be disclosed in the balance sheet. DTA and DTL, both should not be disclosed simultaneously for the same period. Deferred taxes are disclosed as current assets/liabilities under a separate heading in the balance sheet.
Comparison between AS 22 and IND AS 12
| Basis | AS 22 Accounting for Taxes on Income | IND AS 12 (Income taxes) |
| Recognition | AS 22 recognized tax effect of differences between taxable income and accounting income. | IND AS 12 recognized tax effect of differences between assets and/or liabilities and their tax base. |
| Approach | AS 22 is based on profit or loss statement approach. | IND AS 12 is based on balance sheet approach. |
| Differences | The types of differences on which AS 22 is applied are timing differences and permanent differences. | The types of differences on which IND AS 12 is applied are taxable temporary differences and deductible temporary differences.
Permanent differences are not dealt in by this standard. |
| Recognition of Deferred tax asset/deductible temporary differences | DTA is recognized only when and to the extent there is a reasonable certainty of its realization | Deductible temporary differences are recognized to the extent of the probability of taxable profits in future periods. |
| Disclosure | AS 22 deals with the disclosure of DTA/DTL in the balance sheet. | IND AS 12 deals with the recognition of current or deferred tax as income or expense in profit and loss statement. It also deals with the disclosure of out of profit and loss transaction in the balance sheet as current or non-current assets/liability. |
| Revaluation of assets | AS 22 does not cover the difference arising between taxable income and accounting income due to the revaluation of assets. | IND AS 12 deals with the difference between carrying the amount of revalued asset and its tax base. |
| Goodwill | AS 22 does not cover the difference arising due to goodwill arising a business combination. | As per IND AS 12, the difference between carrying the amount of goodwill and its tax base (which will be NIL) is the taxable temporary difference. It does not allow the recognition of such difference because goodwill is measured as a residual and its recognition would increase the carrying amount of goodwill. |
| The concept of virtual certainty | When an entity has unabsorbed depreciation or carry forward of losses then in such a case deferred tax asset should be to the extent there is a virtual certainty supported by convincing evidence. | There is no concept of virtual certainty in IND AS 12. Deductible temporary differences are recognized to the extent of the probability of taxable profits in future periods. |
| Tax holiday | AS 22 specifically provides guidance regarding recognition of deferred tax in the situations of Tax Holiday under Sections 80-IA, 80-IB, 10A and 10B of Income-tax Act. | IND AS 12 does not specifically deal with the situations of the tax holiday. |
| Capital Loss | AS 22 provides guidance regarding recognition of DTA in case of loss under the head of ‘capital gains’. | IND AS 12 does not specifically provide for the same. |
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