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Deferred Tax Assets: Definition, Types, and Treatment

by | Apr 26, 2024 | Income Tax | 0 comments

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Important Keyword: Deferred Tax Assets, Income from Business & Profession, Income Tax.

Deferred Tax Assets: Definition, Types, and Treatment

Each fiscal year, organizations compile two distinct financial reports: an income statement and a tax statement. The motivation for crafting these separate reports stems from disparities in the guidelines governing their preparation. This contrast lays the groundwork for deferred tax, a significant accounting concept.

Deferred Tax Assets arises due to differences between the figures reported in a company’s income statement and those presented in its tax statement. These variations emerge from divergent accounting standards and taxation regulations. As a result, certain income or expenses may be recognized at different times or in varying amounts across the two reports.

Deferred Tax Assets serves as a mechanism to reconcile these disparities over time, ensuring consistency and accuracy in financial reporting. It represents the future tax consequences of transactions or events that have occurred but have not yet been recognized for tax purposes.

What is Deferred Tax?

It serves to align a company’s current tax obligations with its future tax liabilities, ensuring a comprehensive portrayal of its financial position. It plays a pivotal role in financial reporting, with its presence noted in an organization’s balance sheet.

One of the primary drivers of deferred tax is timing differences, which stem from variances in the recognition of income or expenses between financial accounting standards and tax regulations. These differences can be categorized into temporary differences and permanent differences.

Temporary differences represent disparities between taxable income and accounting income that are capable of reversal in subsequent periods. On the other hand, permanent differences arise from variances that do not reverse over time.

Deferred Tax Liability (DTL) emerges when tax relief is granted in advance of recognizing an accounting expense or liability, or when income is accrued but remains untaxed until a later period. In essence, DTL reflects the tax consequences of timing differences, indicating when a tax liability accrues compared to when it is payable.

Conversely, deferred tax assets (DTA) arise when a company’s income statement differs from its corresponding tax statement, allowing for either prepayment of tax liabilities for future periods or reduction of tax liabilities in subsequent fiscal years. These variations result in Deferred Tax Assets, signifying potential tax benefits available to the organization.

By recognizing deferred tax liabilities and assets, companies can provide stakeholders with a more accurate depiction of their tax obligations and potential future tax benefits. This enhances transparency and facilitates informed decision-making regarding the company’s financial health and prospects.

The effects of deferred taxes i.e. Deferred Tax Assets and DTL in the financial statements are as under:
Sl. NoProfit StatusCurrent TreatmentFuture TreatmentEffect
1Book profit higher than the Taxable profitPay less tax nowPay more tax in futureCreates Deferred Tax Liability (DTL)
2Book profit is less than the Taxable profitPay more tax nowPay less tax in futureCreates Deferred Tax Asset (DTA)

Scenarios where Deferred Tax is Recorded

Unrealized Revenues and Expenses:

According to the Income Tax Act, revenues not yet realized by companies are not subject to taxation. Consequently, when there are unrealized receivables from debtors, although recognized in the income statement, they are not considered for taxation. This mismatch in revenue treatment results in a deferred tax liability since taxes will be paid at a later date upon realization of these receivables. Similarly, expenses recorded in books but not yet incurred are not factored into tax calculations. This discrepancy leads to a situation where the gross profit in a company’s books is lower than what appears in its tax statement, resulting in the creation of a deferred tax asset.

Difference in Depreciation Calculation Method:

Divergence in the method of depreciation calculation between a company and the Income Tax Department creates deferred tax. For instance, if a company calculates depreciation using the straight-line method while the tax department follows the Written Down Value method, a temporary difference arises. This discrepancy affects the tax liability, leading to a deferred tax liability. Although adjustments are made over time to reconcile these differences, they create future financial obligations, thus necessitating the recognition of deferred tax.

Difference in Depreciation Percentage:

A disparity in the percentage of depreciation calculation between a company and the tax department can also result in deferred tax creation. For example, if a company calculates depreciation at 10% while the tax department prescribes 15%, a temporary difference emerges. This difference affects the tax liability, resulting in the creation of a deferred tax asset or liability depending on the direction of the variance.

Gross Loss:

When a company realizes a gross loss in a particular year, it creates an opportunity to carry forward the loss to subsequent years to offset future profits and reduce tax liability. This realization of a gross loss leads to the recognition of a deferred tax asset in the year when the loss is incurred.

  1. Concept of Deferred Tax:
    • Represents the variance between gross profit in a Profit & Loss Account and a tax statement.
    • Reflects temporary differences in accounting treatment for financial reporting and tax purposes.
  2. Example Illustration:
    • Company ABC reports a gross profit of INR 500,000 in its Profit & Loss Account.
    • However, its tax statement shows a taxable income of INR 450,000 due to variations in accounting standards.
  3. Calculation Process:
    • Gross Profit (Profit & Loss Account): INR 500,000
    • Taxable Income (Tax Statement): INR 450,000
    • Difference: INR 50,000 (Deferred Tax)
  4. Treatment:
    • The INR 50,000 represents the deferred tax liability or asset, depending on the direction of the difference.
    • If the taxable income is lower than the reported profit, it creates a deferred tax asset; conversely, if it’s higher, it results in a deferred tax liability.

Understanding deferred tax calculation is essential for accurate financial reporting and tax compliance. It helps businesses manage their tax obligations effectively while ensuring transparency and consistency in accounting practices.

ParticularsAs per Books (INR)As per Tax   (INR)
Total income10000001000000
Expenses400000400000
Gross profit before depreciation and tax600000600000
Depreciation10000080000
Gross Profit after depreciation5000000520000

In this scenario, since the computed depreciation differs by INR 20,000, the taxable incomes also differ by the same amount. Consequently, the tax liability for both cases varies accordingly. For instance, at a tax rate of 25%, the tax liability on INR 5,20,000 amounts to INR 1,30,000. However, based on its books, the tax liability should have been INR 1,25,000. This results in an additional tax payment of INR 5,000 for the current year, leading to the creation of a Deferred Tax Asset (DTA).

Benefits of Deferred Tax Assets

While deferred tax does not inherently offer direct benefits, its recognition serves as a crucial aspect of financial planning for organizations. Identifying deferred tax liabilities enables organizations to prepare for forthcoming expenses, thereby ensuring financial stability and foresight. Conversely, the acknowledgment of deferred tax assets presents an opportunity to substantially mitigate future tax liabilities. By leveraging such assets, organizations can effectively reduce their tax burdens in subsequent periods, contributing to enhanced financial efficiency and optimization.

Read More: Fixed Costs

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Official Income Tax Return filing website: https://incometaxindia.gov.in/

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