What is deferred tax?

Deferred tax represents the taxes that are postponed or advanced to future periods due to temporary difference between the accounting income and taxable income. Deferred tax involves recognising these differences,which arise from various factors, including differing treatments of income and expenses under accounting standards and tax laws

 

Firstly, deferred tax can be recorded when taxes on income vary from the amount of taxes a company has already paid. For example, if income tax for one year was calculated at Rs.1,000, but the actual taxes paid was Rs.800, deferred tax of Rs.200 should be recorded for that year for income tax purposes. In other words, deferred tax is the amount yet to be paid and needs to be adjusted in the company’s books of accounts at the end of every financial year.

 

Secondly, deferred tax can also occur when there are differences between taxable profits and accounting profits due to deferred expenses or deferred incomes. For example, deferred tax liability would arise if an expense incurred during a particular period has been deferred till the next year while preparing financial accounts. Similarly, if income earned in a particular period has been deferred till next year while preparing accounts, deferred tax liability will also occur.

 

Types of Deferred Tax

Deferred Tax Assets: At times, a company shows a lower tax payable on its accounting profit than on the profit in its income tax return. Hence, it pays more tax to authorities than it records in its books of accounts. So, to deal with it, it has to record a deferred tax asset in its accounting books in the current financial year.

 

Examples of Deferred tax asset

A.                    when there is a difference between accounting rules and tax rules. For example, deferred taxes exist when expenses are recognized in a company's income statement before they are required to be recognized by the tax authorities or when revenue is subject to taxes before it is taxable in the income statement.

 

B.                     Deferred tax asset is the carryover of losses. If a business incurs a loss in a financial

year, it usually is entitled to use that loss to lower its taxable income in the following years. Because the loss will save the company money on its taxes in the future, the loss becomes an asset.

 

Deferred Tax Liabilities: Often, companies face a situation in which the tax on their accounting profit is higher than the tax they have to pay to authorities in the current financial year. The lower tax they actually pay to tax authorities this year has to be paid at some point in the future. So, to adjust it, they record a deferred tax liability.

 

Example of Deferred tax liabilities

A.                    Depreciation - Company A purchases equipment for $100,000. For tax purposes, it depreciates the asset over 5 years, while for accounting purposes, it depreciates it over 10 years. This difference in depreciation methods creates a deferred tax liability.

B.                     Revenue Recognition - Company B recognizes revenue upfront for accounting purposes but defers it for tax purposes until it's earned. This difference in revenue recognition creates a deferred tax liability.

 

WHAT ARE THE TEMPORARY DIFFERENCE IN DEFERRED TAX?

 

Taxable temporary differences - Taxable temporary differences result from the carrying amount of an asset exceeding its tax base or when the tax base of a liability exceeds its carrying amount. Deductible temporary differences - Deductible temporary differences result in a deferred tax asset when the tax base of an asset exceeds its carrying amount and, in the case of a liability, when the carrying amount of the liability exceeds its tax base., that results in the reduction of taxable income in Balance Sheet.

The recognition of deferred tax assets is allowed to the extent, that there is a reasonable expectation of future profits against which asset or liability (that give rise to deferred tax asset), can be recovered or settled.

 

WHAT ARE THE PERMANENT DIFFERENCE IN DEFERRED TAX?

 

 

Permanent differences are differences between tax laws and accounting standards that will not be reversed at some future date. Because they will not be reversed at a future date, these differences do not give rise to deferred tax. These items typically include the following:

 

?                          Income or expense items not allowed by tax legislation, such as penalties and fines that are considered expenses for financial reporting purposes, but are not deductible for tax purposes; and

 

?                         Tax credits for some expenditures that directly reduce taxes. An example is tax credits provided by tax authorities to encourage the purchase of solar power or an electric vehicle.

 

Because no deferred tax item is created for permanent differences, all permanent differences result in a difference between the company’s tax rate and its statutory corporate income tax rate.

 

Impact on Business Performance & Valuation

 

 

1.                      Reliance Industries Limited reported a deferred tax asset of Rs. 3,789 crore and a deferred tax liability of Rs. 16,830 crore as of March 31, 2020, resulting in a net deferred tax liability of Rs. 13,041 crore. The deferred tax asset was mainly due to the carryforward of unabsorbed depreciation and losses, which can be used to reduce future taxable income. The deferred tax liability was mainly due to the difference in depreciation methods for property, plant and equipment, and intangible assets

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2.                      HDFC Bank Limited reported a deferred tax asset of Rs. 1,452 crore and a deferred tax liability of Rs. 2,244 crore as of March 31, 2020, resulting in a net deferred tax liability of Rs. 792 crore. The deferred tax asset was mainly due to the provision for bad and doubtful debts, which can be used to reduce future taxable income. The deferred tax liability was mainly due to the difference in the tax basis and the book value of investments, such as bonds and securities.

 

Impact on Balance Sheet

Deferred taxes can significantly impact a company's balance sheet in several ways: Asset

1.        Deferred Tax Asset - A deferred tax asset represents a future tax benefit that can reduce taxable income. It's reported as a non-current asset on the balance sheet.

2.      Increase in Assets - Recognition of a deferred tax asset increases total assets.

 

 

Liabilities

1.       Deferred Tax Liability - A deferred tax liability represents a future tax payment that will be made when temporary differences reverse. It's reported as a non-current liability on the balance sheet.

2.      Increase in Liabilities - Recognition of a deferred tax liability increases total liabilities.

 

Equity

1.         Impact on Retained Earnings -            Deferred tax expenses or benefits can impact retained earnings, affecting equity.

2.       Decrease in Equity - If deferred tax expenses increase, retained earnings decrease, reducing equity.

 

Impact on Profit and Loss Statement

?                       Deferred Tax Expense

1.       Increase in Tax Expense - A deferred tax expense increases the total tax expense, reducing net profit.

2.      Decrease in Net Profit - An increase in deferred tax expense can decrease net profit.

?                       Deferred Tax profit

1.       Decrease in Tax Expense - A deferred tax benefit decreases the total tax expense, increasing net profit.

2.      Increase in Net Profit - A decrease in deferred tax expense can increase net profit.

Impact on Cash Flow Statement

While deferred taxes don't directly impact cash flows, they can have an indirect impact:

1.       Changes in Deferred Tax Balances - Changes in deferred tax balances can impact cash flow from operations when the temporary differences reverse.

2.       Tax Payments - When deferred tax liabilities are settled, tax payments can impact cash flow from operations.

 

Impact on Financial Ratios

Deferred taxes can also impact various financial ratios:

1.      Debt-to-Equity Ratio

Deferred tax liabilities can increase a company's debt, affecting its debt-to-equity ratio.Higher debt-to-equity ratio, potentially indicating higher financial risk

 

2.      Return on Equity (ROE)

Deferred tax expenses or benefits can impact a company's