Question

Why do deferred tax assets or deferred tax liabilities arise? Explain your answer with suitable example. The reason for the deferred tax assets and liabilities have been explained with suitable example. Explain The concepts of temporary difference, taxable temporary difference, deductible temporary differences have been linked to DTA and DTL.

Answer 1

Step 1 What Is a Deferred Tax Asset?How Deferred Tax Assets Arise? suitable example?

Meaning

Items on a company's balance sheet that may be used to reduce taxable income in the future are called deferred tax assets. The situation can happen when a business overpaid taxes or paid taxes in advance on its balance sheet. These taxes are eventually returned to the business in the form of tax relief. Therefore, an overpayment is considered an asset to the company. A deferred tax asset is the opposite of a deferred tax liability, which can increase the amount of income tax owed by a company. 

• A deferred tax asset is an item on the balance sheet that results from an overpayment or advance payment of taxes.

• It is the opposite of a deferred tax liability, which represents income taxes owed.

• A deferred tax asset can arise when there are differences in tax rules and accounting rules or when there is a carryover of tax losses.

 

How Deferred Tax Assets Arise?

• The simplest example of a deferred tax asset is the carryover of losses. If a business incurs a loss in a financial year, it usually is entitled to use that loss in order to lower its taxable income in the following years.2 In that sense, the loss is an asset.

 

• Another scenario where deferred tax assets arise is when there is a difference between accounting rules and tax rules. For example, deferred taxes exist when expenses are recognized in the income statement before they are required to be recognized by the tax authorities or when revenue is subject to taxes before it is taxable in the income statement. Essentially, whenever the tax base or tax rules for assets and/or liabilities are different, there is an opportunity for the creation of a deferred tax asset.

 

Example of Deferred Tax Asset

 

A computer manufacturing company estimates, based on previous experience, that the probability a computer may be sent back for warranty repairs in the next year is 2% of the total production. If the company's total revenue in year one is $3,000 and the warranty expense in its books is $60 (2% x $3,000), then the company's taxable income is $2,940. However, most tax authorities do not allow companies to deduct expenses based on expected warranties; thus the company is required to pay taxes on the full $3,000.

 

If the tax rate for the company is 30%, the difference of $18 ($60 x 30%) between the taxes payable in the income statement and the actual taxes paid to the tax authorities is a deferred tax asset.

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Step 2What Is a Deferred Tax Liability?How Deferred Tax Liability Arise? suitable example?

Meaning

Deferred tax liability is a tax that is assessed or is due for the current period but has not yet been paid—meaning that it will eventually come due. The deferral comes from the difference in timing between when the tax is accrued and when the tax is paid. A deferred tax liability records the fact the company will, in the future, pay more income tax because of a transaction that took place during the current period, such as an instalment sale receivable.

• A deferred tax liability represents an obligation to pay taxes in the future.

• The obligation originates when a company or individual delays an event that would cause it to also recognize tax expenses in the current period.

• For instance, earning returns in a qualified retirement plan, like a 401(k), represents a deferred tax liability since the retirement saver will eventually have to pay taxes on the saved income and gains upon withdrawal.

 

How Deferred Tax Liability Arise?

 

• A common source of deferred tax liability is the difference in depreciation expense treatment by tax laws and accounting rules. The depreciation expense for long-lived assets for financial statement purposes is typically calculated using a straight-line method, while tax regulations allow companies to use an accelerated depreciation method. Since the straight-line method produces lower depreciation when compared to that of the under accelerated method, a company's accounting income is temporarily higher than its taxable income.

 

• Another common source of deferred tax liability is an instalment sale, which is the revenue recognized when a company sells its products on credit to be paid off in equal amounts in the future. Under accounting rules, the company is allowed to recognize full income from the instalment sale of general merchandise, while tax laws require companies to recognize the income when instalment payments are made. This creates a temporary positive difference between the company's accounting earnings and taxable income, as well as a deferred tax liability.

 

Example of Deferred Tax Liability

 

Consider a company that sold a $1,000 piece of furniture with a 20% tax rate, which is paid for in monthly installments by the customer. The customer will pay this over two years ($500 + $500). For financial purposes, the company will record a sale of $1,000. Meanwhile, for tax purposes, they will record it as $500. As a result, the deferred tax liability would be $500 x 20% = $100. 

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temporary difference, taxable temporary difference, deductible temporary difference

The company derives its book profits from the financial statements prepared in accordance with the rules of the Companies Act and calculates its taxable profit based on the provision of the Income Tax Act. There is a difference between the book profit and taxable profit because of certain items which are specifically allowed or disallowed each year for tax purposes. This difference between the book and the taxable income or expense is known as timing difference and it can be either of the following:

• Temporary Difference – Differences between book income and tax income that is capable of being reversed in the subsequent period.

 

• Permanent Difference – Differences between book income and tax income which is not capable of being reversed in the subsequent period.