Financial accounting and tax principles: in the first of two articles about accounting for taxation under IAS12, Teresa Marsh explains what deferred tax is and how to deal with it.
| Author | Marsh, Teresa |
| Position | Study notes: PAPER P7 |
It is important to understand how to account for taxation, because it has an impact on the income statement (in the tax expense account) and the balance sheet (in the income tax and deferred tax accounts). The tax expense on the income statement has three components: the tax charge for the period; any under- or over-provision of tax for the previous period; and the increase or decrease in the deferred tax provision. Let's focus here on the third component.
Before addressing how to account for deferred tax, you should know what it is and how it arises. The tax charge is calculated on a company's taxable profit, not its accounting profit. These two figures are rarely the same, as there will be some expenses included in arriving at the accounting profit that are not allowed as a deduction from taxable profit. In the UK, for example, entertaining customers is not an allowable tax deduction against profit, so that amount is added back to the accounting profit to arrive at the taxable profit. Differences that are never allowable are known as permanent differences. But some aren't permanent, because they are allowed as a deduction against taxable profit in a different period from which they are deducted from the accounting profit. These are called temporary differences, as they will reverse in future and give rise to deferred tax. The most common example is depreciation: a temporary difference arises because the rate of depreciation given for accounting purposes is usually slower than the rate of depreciation given for tax purposes.
The following example illustrates why we account for deferred tax and shows its effect on the income statement. Imagine that firm X has accounting profits of 500,000 [pounds sterling] in each of its first four years. The figure of 500,000 [pounds sterling] has been arrived at after charging depreciation of 25,000 [pounds sterling] ayear on a non-current asset bought for 100,000 [pounds sterling] on the first day of X's first year. The equivalent tax depreciation is 100 per cent--ie, 100,000 [pounds sterling] given in year one. The rate of income tax is 30 per cent.
The tax charge, based on taxable profits, is derived in table 1. The accounting depreciation has been added back, because it's not an allowable expense for tax purposes. Tax depreciation is given as a deduction instead.
Based on what we've done so far, the income statement would look like table 2. From it we can see that profit before tax is the same for all...
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