What is deferred tax?
Deferred tax relates to overpaid or owed tax due to temporary timing differences. This can result in an asset or a liability. There can only be either deferred tax liability or deferred tax asset included on a company’s balance sheet, there cannot be both. It depends on whether tax has been overpaid or if it is owed that it is considered an asset or liability.
Taxable temporary differences occur when a company holds an asset with a liability value that does not agree with the taxable value of the asset. This is due to accounting standards and tax standards recording depreciation in different methods. The aim of deferred tax is to account for the difference in value.
These differences can result in income and expenditure being accounted for in one period, while the tax amount is payable in another accounting period.
Deferred tax liability
Deferred tax is usually a liability, where the amount is payable in a future accounting period. This happens when the income from one period is less than the estimated tax, so to rectify this the difference is included on the balance sheet as a liability.
Company ABC owns equipment which they have capitalised as fixed assets. ABC use a depreciation method that accounts for a higher depreciation rate in the initial years of use, and a lower depreciation rate as the years go on.
As tax will account for the asset on a straight-line basis, the depreciation for tax purposes will be evenly spread over the specific period of time regardless of the useful life of the asset. The depreciation charges are not tax deductible, instead, they can be claimed for capital allowance.
As ABC will have a higher depreciation deduction than tax authorities, they will have more income in their accounts than the taxable income. The difference is therefore included as a deferred tax liability on the balance sheet.
Deferred tax asset
In the case where a company has overpaid tax in one period, this will result in a deferred tax asset on the balance sheet. This happens when a company has paid tax in advance or overpaid, and by recording this amount as an asset it shows that the company will receive this amount as a repayment, or it will be offset against a future tax return. This can be used by a company that knows it will have a high tax liability in a future period, so it pays in advance to offset its liability in the future.
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