IAS 12 Income Taxes defines deferred tax liabilities as the amounts of income taxes payable in future periods in respect of taxable temporary differences. Temporary differences are differences between the carrying amount of an asset or liability in the statement of financial position (balance sheet) and its valuation for tax purposes. These temporary differences arise when the tax due for a particular accounting period is deferred because of the impact of capital allowances and other factors.
Capital allowances are tax deductible while depreciation is not tax deductible. Financial accounting allows for depreciation as an expense which is charged as a proportion of the cost of a non-current asset but does not allow the deduction of capital allowance as an expense.
On the other hand, Taxation allows for capital allowances as a tax deductible item which is charged as the total cost of the asset but does not allow for depreciation as a tax deductible item.
Depreciation has to be added back in computing the taxable profit of a company.
In the year capital allowance is claimed against the cost of the asset, the capital allowance is deducted from the profit for the year and the depreciation is added back. As capital allowance is always higher than the deprecation of the new non-current asset, you will realise that the tax liability for that year will be lower than subsequent years where the capital allowance will not be claimable but the depreciation charge will still need to be added back for such subsequent years.
For example, a company made a profit of £171,000 in 20X1 and a qualifying asset was bought during that year for £100,000 and this will have a useful life of 8 years and no residual value at the end of its useful life. In 20X2, the company also made a profit of £171,000 and that asset is still in use by the company. Tax is charged at 20%.
Depreciation on the asset = £100,000/ 8 years = £12,500 per year.
Add back depreciation 12,500
Less: Capital allowances (100,000)
Taxable profit 83,500
Tax (20% of £83,500) 16,700
Add back depreciation 12,500
Tax (20% of £183,500) 36,700
Difference in tax liability arising due to capital allowance = £36,700 - £16,700 = £20,000
The tax in 20X1 is less by £20,000 due to capital allowance which has been claimed but as capital allowance can only be claimed once on each asset, the tax in 20X2 has increased as depreciation still has to be added back.
Deferred tax is a way of applying the accruals concept to accounting for corporation tax.
Deferred tax implies that the tax for an earlier accounting period has been pushed into later accounting periods. Financial accounting requires that these future increased tax liability should be recognised as a provision, which is a liability in the financial statements.
Dr - Deferred tax expense in the Statement of profit or loss £20,000
Cr - Deferred tax liability in the Statement of financial position (balance sheet) £20,000
In applying the accruals concept in financial accounting, an aim is made to ensure that the profit is not overstated in 20X1, hence the expense in the Statement of profit or loss account is increased and the current liability in the Statement of financial position (balance sheet) is also increased as this is tax which is expected to be paid in the next accounting period.
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