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Taxes are a big part of running a business affecting the profitability and cashflow. Sometimes, there is a difference between the tax that a business pays to the government and the tax that it reports on its financial statements. This difference is called deferred taxation.
In this article, we will look at how deferred taxation works in the business context and how it may impact the financial performance and tax planning of a business.
The difference between current tax and deferred tax
These are two types of taxes that a business has to deal with on its financial statements.
Current tax: Current tax is the amount of tax that a business pays to the government in the current year, based on the taxable income and the tax rate of that year. It is the sum due (or recoverable) from past and present taxable gains (or losses).
Deferred tax: The amount of tax that a company anticipates paying or receiving in the future, depending on the short-term variations between its taxable and accounting income, is known as deferred income tax.
The types of deferred tax: Deferred tax asset and deferred tax liability
Temporary differences are the differences between the income and expenses that a business recognises on its financial statements and the income and expenses that the government recognises for tax purposes.
Depending on the direction and timing of these differences, deferred tax can be either an asset or a liability for the business.
Deferred tax asset (DTA)
The amount of taxes that a business has overpaid or may overpay in the current year and that it may be able to recover or lower in the future is known as a deferred tax asset. When the taxable income of a business is higher than its accounting income in the current year and when this difference will reverse in the future, a deferred tax asset tends to arise.
Deferred tax liability (DTL)
A business’s deferred tax liability is the total amount of taxes it has underpaid or will underpay this year and will have to pay or incur an increase in subsequent years. A deferred tax liability occurs when a business’s accounting income in the current year exceeds its taxable income, and this gap is expected to reverse in subsequent years.
The deferred tax asset and the deferred tax liability will cancel each other out over the life of the asset or the debt, and the total tax that the business will pay will be the same as if it had used the same accounting method and rule for both purposes.
Examples of deferred tax liability in the business context
Revenue recognition
Some businesses report income on their financial accounts before collecting consumer payments or supplying products or services. This is called the accrual method of accounting.
Nevertheless, until the companies truly receive or send the money, the government might not permit them to record it on their tax returns. This is what we know as the cash method of accounting. Because businesses will have to pay more tax later on when they record the revenue on their tax returns, this results in a deferred tax liability for them.
Prepaid expenses
Paying for some expenses in advance, such as rent, insurance, or subscriptions, is what some businesses do. These expenses are referred to as prepaid expenses.
However, these expenses may not be deducted from the taxable income of businesses by the government until they are consumed or used. This leads to a deferred tax liability for the businesses.
Inventory valuation
Some businesses may calculate their inventory value differently on their financial statements and their tax returns. This may lead to a deferred tax liability on the balance sheet. There may be other sources of deferred tax liability, depending on the specific accounting policies and tax laws that apply to a business.
Conclusion
One significant factor that may affect cash flow is deferred tax assets and liabilities. If you own a business, deferred tax assets and expenses are one thing that is crucial to understand for a better tax approach and cash flow management.
FAQs
Yes, deferred tax is calculated on the loss if the loss is temporary and expected to reverse in the future. Deferred tax on loss creates a deferred tax asset, which reduces the future tax liability or increases the future tax refund.
Deferred tax is created because of the differences between book income and taxable income for a period. These differences are called timing differences, as they arise in one period and reverse in subsequent periods. Deferred tax reflects the future tax consequences of these differences.
If deferred tax is negative, it means that the company has a deferred tax asset. This implies that the company has paid more tax than its accounting income and expects to pay less tax in the future. A deferred tax asset can reduce the company’s tax liability.
No, tax-deferred is not tax-free. Tax-deferred means that the tax on the income or gains is postponed until a later date, usually when the money is withdrawn or liquidated. Tax-free means that the income or gains are not subject to any tax at all.
To calculate DTA (deferred tax asset), multiply the temporary difference by the tax rate. For example, if the temporary difference is ₹100 and the tax rate is 20%, then DTA = 100 x 0.2 = ₹20.