Understanding Deferred Tax: Calculation and Significance

Deferred tax, an important concept within the realm of accounting and taxation, is a key aspect for businesses and individuals to comprehend. This article delves into what deferred tax is, how it is calculated, and why it is necessary for financial accuracy and tax compliance.

Introduction to Deferred Tax

Deferred tax refers to the tax effect resulting from temporary differences between accounting income, as recognized under the Companies Act 2013, and taxable income, as defined by the Income Tax Act 1961. These differences occur when transactions are recorded in financial statements according to accounting standards but recognized for tax purposes at different times.

What is Deferred Tax?

Deferred tax impacts are found in several scenarios, such as:

Accumulated depreciation: A company may use straight-line depreciation for accounting purposes, while tax regulations might allow for a different method, leading to differences in the timing of tax deductions. Fines and penalties: Penalties recognized in financial statements may not be deductible for tax purposes. Employee benefits: Benefits provided to employees, such as contributions to pension funds, might differ between financial and tax reporting.

How is Deferred Tax Calculated?

The calculation of deferred tax involves the following steps:

Determine Temporary Differences: Identify the elements in the financial statements that create differences between accounting income and taxable income. Effective Tax Rate: Identify the corporation's effective tax rate for the current year and future years. Deferred Tax Assets (DTAs) and Liabilities (DTLs): DTAs: These are created when there are future taxable temporary differences and a more favorable future tax rate is expected. DTLs: These are created when there are future deductible temporary differences and a less favorable future tax rate is anticipated.

Why is Deferred Tax Necessary?

The necessity of deferred tax is pivotal for several reasons:

Accurate Financial Statements: Deferred tax adjusts the financial statements to reflect the true tax liability, providing a more accurate picture of the company's financial health. Compliance with Tax Regulations: It ensures that businesses comply with tax laws and regulations, avoiding penalties and legal issues. Planning and Forecasting: Accurate calculation of deferred tax aids in strategic financial planning and forecasting, enabling better management of cash flows. Consistency: Deferred tax helps maintain consistency between the company's accounting practices and the financial reporting standards.

Conclusion

Deferred tax is a crucial concept that businesses and individuals must understand for accurate tax reporting and compliance. By comprehending the calculation and necessity of deferred tax, stakeholders can make informed decisions, manage financial risks, and achieve tax optimization.

Frequently Asked Questions

Q: What is the main difference between accounting income and taxable income?
A: Accounting income is calculated according to the accounting standards set by the Companies Act 2013, while taxable income is calculated according to the Income Tax Act 1961. The differences arise from varying interpretations of the same transactions.

Q: How often should deferred tax be reviewed?
A: Deferred tax should be reviewed at least annually and whenever significant transactions occur, such as the acquisition or disposal of assets, changes in tax rates, or in accounting policies.

Q: Can deferred tax be negative?
A: Yes, deferred tax can be negative, typically indicating that the company is entitled to future tax benefits, such as deductions or credits, that will reduce its future tax liability.

References

1. Companies Act 2013 2. Income Tax Act 1961 3. AccountingTools - Deferred Tax