Deferred Tax in simpler terms

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As per IAS 12, a Deferred Tax Liability is the
income tax that will be due in the future because
of taxable temporary differences. To fully grasp
this definition, we need to understand what
temporary differences mean.
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Temporary differences refer to the difference
between an asset's carrying amount (CA) in the
financial statement and its tax base (TB), which
is the amount attributed to that asset or
liability for tax purposes. In financial
statements, Non-Current Assets (NCA) are
subjected to depreciation, while for tax
purposes, NCA are subjected to tax deductions,
also known as capital allowance. The difference
between the two depreciations results in a
temporary difference between the carrying amount
and the tax base. To illustrate further, let's
consider an example of a Non-Current Asset worth
1000 that was purchased at T0, which is
depreciated on a straight-line basis over two
years, with an annual depreciation of 500. The
tax depreciation granted by the tax authority is
T1 - 750 and T2 - 250. The carrying amount of
the asset at T1 is 500, while the tax base is
250. The temporary difference at T1 is 250
(500-250).
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How does this example result in future tax
payment?
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Entities pay income tax on their taxable profits,
which are calculated by adding back depreciation
and deducting tax depreciation from the
accounting profit and loss. In the above
example, the tax depreciation (750) is greater
than depreciation (500) in T1. The entity has
received early tax relief, and as a result, the
payment of tax is deferred. However, this tax
difference is temporary as tax will be paid in
the future. In year 2, when the tax depreciation
(250) is less than the depreciation charged
(500), the entity is liable to pay additional
tax. In accordance with the accrual and matching
principle, revenue or expenses are recorded when
a transaction occurs rather than when the payment
is received or made. The matching principle also
requires that revenue and expenses should be
recognized in the same period. Therefore, a
Deferred Tax Liability is recorded, equal to the
expected tax payable in the future. Assuming a
tax rate of 20, the deferred tax liability
recognized at T1 will be 20 x 250 50. Please
feel free to contact Cheylesmore Chartered
Accountants for help sorting this out for you.
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