Dada Adefolami

Tax law is an area of legal study dealing with the constitutional, common-law, statutory, tax treaty, and regulatory rules that constitute the law applicable to taxation.
Deferred tax is accounted for in accordance with IAS 12, Income Taxes., deferred tax normally results in a liability being recognized within the Statement of Financial Position. IAS 12 defines a deferred tax liability as being the amount of income tax payable in future periods in respect of taxable temporary differences. So, in simple terms, deferred tax is tax that is payable in the future. However, to understand this definition more fully, it is necessary to explain the term ‘taxable temporary differences’.

Temporary differences are defined as being differences between the carrying amount of an asset (or liability) within the Statement of Financial Position and its tax base i.e. the amount at which the asset or liability is valued for tax purposes by the relevant tax authority.

Taxable temporary differences are those on which tax will be charged in the future when the asset or liability is recovered or settled.
An asset that may be used to reduce any subsequent period’s income tax expense. Deferred tax assets can arise due to net loss carry-overs, which are only recorded as asset if it is deemed more likely than not that the asset will be used in future fiscal periods.
If there is a change in both the deferredtax asset account (deferredtaxbenefit) and the deferredtax liability account (deferredtaxexpense) the amounts net to be netted together to derive a single amount of deferredtaxexpense or deferredtaxbenefit.

IAS 12 requires that a deferred tax liability is recorded in respect of all taxable temporary differences that exist at the year-end – this is sometimes known as the full provision method.

All of this terminology can be rather overwhelming and difficult to understand, so consider it alongside an example. Depreciable non-current assets are the typical example behind deferred tax.

Within financial statements, non-current assets with a limited economic life are subject to depreciation. However, within tax computations, non-current assets are subject to capital allowances also known as tax depreciation at rates set within the relevant tax legislation. Where at the year-end the cumulative depreciation charged and the cumulative capital allowances claimed are different, the carrying value of the asset cost less accumulated depreciation will then be different to its tax base cost less accumulated capital allowances and hence a taxable temporary difference arises.

Example1:
A non-current asset costing N2,000 was acquired at the start of year 1. It is being depreciated straight line over four years, resulting in annual depreciation charges of N500. Thus, a total of N2,000 of depreciation is being charged. The capital allowances granted on this asset are:
N
Year 1 800
Year 2 600
Year 3 360
Year 4 240
Total capital allowances 2,000

Table 1 shows the carrying value of the asset, the tax base of the asset and therefore the temporary difference at the end of each year.

As stated above, deferred tax liabilities arise on taxable temporary differences, i.e. those temporary differences that result in tax being payable in the future as the temporary difference reverses. So, how does the above example result in tax being payable in the future?

Entities pay income tax on their taxable profits. When determining taxable profits, the tax authorities start by taking the profit before tax (accounting profits) of an entity from their financial statements and then make various adjustments. For example, depreciation is considered a disallowable expense for taxation purposes but instead tax relief on capital expenditure is granted in the form of capital allowances. Therefore, taxable profits are arrived at by adding back depreciation and deducting capital allowances from the accounting profits. Entities are then charged tax at the appropriate tax rate on these taxable profits.

Table 1: The carrying value, the tax base of the asset and therefore the temporary difference at the end of each year (Example 1)

Year Carrying value
(Cost – accumulated depreciation)
N Tax base
(Cost – accumulated capital allowances)
N

Temporary difference
N
1 1,500 1,200 300
2 1,000 600 400
3 500 240 260
4 Nil Nil Nil

In the above example, when the capital allowances are greater than the depreciation expense in years 1 and 2, the entity has received tax relief early. This is good for cash flow in that it delays (i.e. defers) the payment of tax. However, the difference is only a temporary difference and so the tax should be paid in the future. In years 3 and 4, when the capital allowances for the year are less than the depreciation charged, the entity is being charged additional tax and the temporary difference is reversing. Hence the temporary differences can be said to be taxable temporary differences.

Notice that overall, the accumulated depreciation and accumulated capital allowances both
equal N2,000 – the cost of the asset – so over the four-year period, there is no difference between the taxable profits and the profits per the financial statements.

At the end of year 1, the entity has a temporary difference of N300, which will result in tax being payable in the future in years 3 and 4. In accordance with the concept of prudence, a liability is therefore recorded equal to the expected tax payable.

Assuming that the tax rate applicable to the company is 25%, the deferred tax liability that will be recognized at the end of year 1 is 25% x N300 = N75. This will be recorded by crediting (increasing) a deferred tax liability in the Statement of Financial Position and debiting (increasing) the tax expense in the statement of profit or loss.

By the end of year 2, the entity has a taxable temporary difference of N400, i.e. the N300 bought forward from year 1, plus the additional difference of N100 arising in year 2. A liability is therefore now recorded equal to 25% x N400 = N100. Since there was a liability of N75 recorded at the end of year 1, the double entry that is recorded in year 2 is to credit (increase) the liability and debit (increase) the tax expense by N25.

At the end of year 3, the entity’s taxable temporary differences have decreased to N260 (since the company has now been charged tax on the difference of N140). Therefore in the future, the tax payable will be 25% x N260 = N65. The deferred tax liability now needs reducing from N100 to N65 and so is debited (a decrease) by N35. Consequently, there is now a credit (a decrease) to the tax expense of N35.

At the end of year 4, there are no taxable temporary differences since now the carrying value of the asset is equal to its tax base. Therefore the opening liability of N65 needs to be removed by a debit entry (a decrease) and hence there is a credit entry (a decrease) of N65 to the tax expense. This can all be summarized in the following working.

The movements in the liability are recorded in the statement of profit or loss as part of the taxation charge
Year 1
N 2
N 3
N 4
N
Opening deferred tax liability 0 75 100 65
Increase/(decrease) in the year 75 25 (35) (65)
Closing deferred tax liability 75 100 65 0

The closing figures are reported in the Statement of Financial Position as part of the deferred tax liability.
PROFORMA
Example 1 provides a proforma, which may be a useful format to deal with deferred tax within a published accounts question.
The movement in the deferred tax liability in the year is recorded in the statement of profit or loss where:
1. an increase in the liability, increases the tax expense
2. a decrease in the liability, decreases the tax expense.
The closing figures are reported in the Statement of Financial Position as the deferred tax liability.
THE STATEMENT OF PROFIT OR LOSS
As IAS 12 considers deferred tax from the perspective of temporary differences between the carrying value and tax base of assets and liabilities, the standard can be said to take a valuation approach. However, it will be helpful to consider the effect on the statement of profit or loss.
Continuing with the previous example, suppose that the profit before tax of the entity for each of years 1 to 4 is N10,000 after charging depreciation. Since the tax rate is 25%, it would then be logical to expect the tax expense for each year to be N2,500. However, income tax is based on taxable profits not on the accounting profits.

The taxable profits and so the actual tax liability for each year could be calculated as in Table 2 .

The income tax liability is then recorded as a tax expense. As we have seen in the example, accounting for deferred tax then results in a further increase or decrease in the tax expense. Therefore, the final tax expense for each year reported in the statement of profit or loss would be as in Table 3.

It can therefore be said that accounting for deferred tax is ensuring that the matching principle is applied. The tax expense reported in each period is the tax consequences i.e. tax charges less tax relief of the items reported within profit in that period.
Example 1: Proforma
N
Opening deferred tax liability X As given in the trial balance
Increase/(decrease) in the year
Tax rate % x increase / decrease in year-end taxable temporary differences X/(X) This is taken to the taxation charge in the Income Statement
Closing deferred tax liability
Tax rate % x year-end taxable temporary differences X This is reported in the Statement of Financial Position

Table 2: Taxable profit and actual tax liability calculation (Example 1)
Year
1
N Year
2
N Year
3
N Year
4
N
Profit before tax 10,000 10,000 10,000 10,000
Depreciation 500 500 500 500
Capital allowances (800) (600) (360) (240)
Taxable profits 9,700 9,900 10,140 10,260

Tax liability
@ 25% of
taxable profits
2,425
2,475
2,535
2,565

Table 3: Final tax expense for each reported income statement year (Example 1)
Year
1
N Year
2
N Year
3
N Year
4
N
Income tax 2,425 2,475 2,535 2,565
Increase/(decrease) due to deferred tax
75
25
(35)
(65)
Total tax expense (2,500) (2,500) (2,500) (2,500)

Here are some hints on how to deal with the information in the future questions.
1. The deferred tax liability given within the trial balance or draft financial statements will be the opening liability balance.
2. In some cases the notes to the question there will be information to enable you to calculate the closing liability for the statement of financial position or the increase/decrease in the liability.
It is important that you read the information carefully. You will need to ascertain exactly what you are being told within the notes and therefore how this relates to the working that you can use to calculate the figures for your answer.
However, earnings before interest, taxes, depreciation and amortization (EBITDA) is a measurement of financial performance. It is similar to net income with some factors of non-operating expenses added back into the value. Operating income is derived from a simpler calculation and is often considered synonymous with earnings before interest and taxes.

Tax deferral refers to where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes

In accounting and finance, earnings before interest and taxes (EBIT), is a measure of a firm’s profit that includes all expenses except interest and income tax expenses. It is the difference between operating revenues and operating expenses. When a firm does not have non-operating income, then operating income is sometimes used as a synonym for EBIT and operating profit.

EXPECT PART TWO AND CONCLUTIONIN MY NEXT SERIES

Dada Suraju Adefolami, Professor of Finance, School of Business Administration, UNEM University Costa Rica, is a Finance / Management Consultant and Certified Forensic Accountant. You can reach him via: [email protected]; 08052043855