Why do you need to recognize deferred tax?
You should recognize deferred tax not only because the IFRS rules say so, but also because deferred tax is an important accounting measure. It helps to match tax effect of certain transactions with their accounting impact and therefore produce less distorted results.
I’m going to give you 7 simple systematic steps for your own deferred tax calculations using the IFRS rules.
Case study: How to calculate deferred tax
First of all, you should know the rules for deferred tax calculation. In this article we will proceed in line with the standard IAS 12 Income taxes – please watch the video summary of IAS 12 here:-
When you learn by doing it usually helps you more than factual learning, so let’s outline the method for deferred tax calculation on the real-life case study:
In the beginning of the year 1, ABC Corp. acquired a machinery for 100 000 CU (currency units) and plans to depreciate it over 5 years. In the year 1, ABC booked depreciation charge of 20 000 CU.
According to income tax law applicable in ABC’s country, ABC can annually deduct 25% of machinery’s cost for tax purposes.
During the year 1, ABC declared to pay health care benefits to its employees at the retirement day. As a result, ABC recognized a cost and a provision of 6 000 CU. However, health care benefits are tax deductible only when they are actually paid.
Simplified version of ABC’s statement of financial position (balance sheet) looks as follows:
Calculate deferred tax as of 31 December Year 1. Assume tax rate of 20% and no temporary differences other than those stated above.
Further information: ABC’s tax loss carried forward from previous periods is 50 000 CU and ABC can deduct this loss against future taxable profits. ABC’s opening deferred tax asset as of 1 January of Year 1 is 9 500 CU.
Step 1: List all assets and liabilities into a table
For the first step, I highly recommend listing all assets and liabilities with their carrying amounts into a table. Just remember the following rules:
- Start your deferred tax calculations AFTER you are done with everything else. Other accounting entries would probably have an impact on the deferred tax.
- State all your assets as positive numbers and all your liabilities as negative numbers. That’s good for checking correctness.
- Bring in also equity accounts. Of course, you don’t calculate any deferred tax on equity, but this way you ensure completeness of your calculation.
- If the table is correct, then the total of all carrying amounts equal to zero.
In our case study, the table will look as follows:
Step 2: Calculate tax bases
Now, it’s time to calculate tax base for each of your assets and liabilities listed in the table.
Standard IAS 12 on Income taxes defines a tax base:
- Of an asset: as the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset; and
- Of a liability: as its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods.
If you’d like to learn more about setting a tax base of your assets and liabilities and understand it for once, please read the following article: The Unconventional Guide to Tax Bases.
In our case study, we will assume that except for machinery and health care liabilities, tax base of ABC’s assets and liabilities equals to their carrying amounts.
Let’s deal with machinery and health care liabilities now.
Machinery: ABC can deduct 25 000 CU for of machinery’s cost for tax purposes (25% of 100 000). How much of machinery’s cost remains for future tax deductions? It is machinery’s cost of 100 000 less amount already deducted in the current (and previous) periods of 25 000. Therefore, machinery’s tax base is 75 000.
Health care liabilities: The expense of 6 000 for creating the provision for health care benefits will be deductible in the future, when the benefits are paid. As it is a liability, its tax base is calculated as liability’s carrying amount of 6 000 less any amount tax deductible in the future – full 6 000 CU. Therefore, liability’s tax base is 0.
We can enter all tax bases into the table, right next to carrying amounts. Don’t worry about equity accounts – there’s no deferred tax and you can enter “n/a” as not applicable.
Thus our table looks as follows:
Step 3: Calculate temporary differences
There’s always a lot of confusion related to the type of a difference and resulting deferred tax. Is it taxable or deductible? Is it deferred tax asset or deferred tax liability?
To avoid this confusion, calculate your temporary differences as tax base less carrying amount (not in the opposite way).
Thus all the differences become logical:
- Taxable temporary differences will be negative, or lower than 0;
- Deductible temporary difference will be positive, or greater than 0.
Here’s how it looks in our table:
Step 4: Determine applicable tax rate
IAS 12 requires measuring deferred tax at the tax rates expected to apply in the period then the asset is realized or the liability is settled. Please be a bit careful here because you cannot use some estimates of the future tax rates. Instead, you need to apply tax rates that are enacted or substantively enacted by the end of the reporting period.
Also, as different tax rates are applicable for different types of transactions, you need to apply the tax rate applicable to expected way of recovery or settlement. For example, read about different tax rates on short term / long term capital gain in India here: Computation of Short Term & Long Term Capital Gain Tax in India.
In our case study, ABC should apply the tax rate of 20%.
Step 5: Calculate deferred tax asset or deferred tax liability
The formula for calculating your deferred tax is:
In the last column of the table, ABC can calculate its deferred tax asset or liability. As the taxable temporary differences give rise to deferred tax liabilities, those are all negative amounts. In ABC’s case, it relates only to machinery.
On the other hand, all deductible temporary differences give rise to deferred tax assets – all positive amounts in this case. In ABC’s case, it relates to health care liabilities.
The net deferred tax position of ABC as at 31 December of Year 1 is deferred tax asset of 200 CU.
Here, you need to take the following issues into account:
- Are these temporary differences really taxable or deductible? There might be some item with permanent difference – for example, liability from government grant that will never be taxable. You need to assess all differences carefully and decide whether some difference must be excluded or not.
- Can you offset individual deferred tax assets and liabilities and present them as 1 net amount? Are all conditions as stated in IAS 12 fulfilled?
Step 6: Revise other items outside the statement of financial position
You might need to recognize deferred tax to items that are outside your statement of financial position. Typical examples are:
- Tax losses from previous years that could be deducted from current or future years’ taxable profit
- Certain expenses paid in the previous periods but tax deductible only when some conditions are met. For example, research expenses might have been paid years ago, but they might be tax deductible only after full research and development is completed.
For this purpose, you need to keep reliable records about all items that adjusted your previous year’s tax return and can have impact on the future tax returns.
ABC carries tax loss from previous periods amounting to 50 000 CU and as this tax loss can be deducted against future taxable profits, then ABC can recognize deferred tax asset at 20% amounting to 10 000 CU.
Step 7: Add up and make up an accounting entry
ABC can add up net deferred tax asset of 200 CU resulting from all temporary differences and deferred tax asset of 10 000 CU resulting from tax loss carried forward.
If all conditions for recognition of deferred tax are met, then ABC’s deferred tax asset shown in the statement of financial position is 10 200 CU.
How should ABC recognize this deferred tax?
Its opening deferred tax asset was 9 500 CU as of 1 January Year 1, therefore ABC needs to increase its deferred tax asset by 700 CU:
In this case, the full increase is recognized to profit or loss, and the entry is to debit deferred tax asset and credit deferred income tax income in profit or loss.
However, if deferred tax asset relates to assets or liabilities recognized to other comprehensive income, then this deferred tax is recognized to other comprehensive income, too.
Final word on Deferred Tax Calculation in IFRS
Your own deferred tax calculation will depend on the specific transactions you might have in your company. Also, you need to make your calculation in line with all the rules set in IAS 12.
When you follow this systematic approach, your success rate will dramatically go up.
If you need clarification or a deeper understanding of Deferred Tax please leave your query in the comments section below and I’ll be back to answer any questions you may need answered.
About the Author – Silvia Mahutova FCCA
Silvia helps people learn IFRS three times faster than they ever expected. Check out her free report Top 7 IFRS Mistakes That You Should Avoid and her free IFRS mini-course on www.ifrsbox.com.