Deferred tax
Deferred tax is an
accounting term, meaning future tax
liability or
asset, resulting from temporary differences between book (accounting) value of assets and liabilities, and their tax value.
The need for deferred tax accounting arises because companies often postpone or pre-pay taxes on profits pertaining to a particular period.
When a company arrives at its profits or losses for a period, it does so after deducting all the expenses, including the tax for the period, from the revenues earned. But a company's profits/losses reported to investors often differ, sometimes substantially, from the profits the taxman lays claim to.
There may be a difference in the way certain items of expense are allowed to be treated for tax purposes and how a company actually treats them.
Tax laws allow a 100% depreciation in the first year after a company acquires certain assets. But a company may actually write off the depreciation over a larger number of years in its financials. The company may charge depreciation at lower rates than allowed under tax laws. Or it may use a different method of charging depreciation.
Tax laws may allow a company to deduct certain expenses in full in a single year, but it may phase out the charge over a number of years.
Under the old system of accounting only for current taxes, the company's profits would be artificially high in the first year (due to the tax savings).
The profits would, however, be lower in the subsequent years, as the tax laws in the subsequent years would not recognise the depreciation charge or the amortised expense, as the case may be.
But the new accounting standard requires that a company carve out a part of its current year's profits (equal to the future tax liability on such transactions) as a deferred tax liability. The deferred tax liability serves the purpose of a reserve, which will be drawn down in the future years to meet the company's higher tax liability in those years.
The tax laws may not recognise some of the expenses that a company has charged off in its accounts. For instance, provisions made at the discretion of the management, such as those for bad debts, which are not fully recognised by tax authorities. And expenses which are accounted for on an accrual basis (that is, when they become due and not when they are actually paid). Companies may charge off duty, cess and tax dues against profits when they become due, but they would be recognised for tax computation only when actually paid.
In such cases, a company is actually pre-paying taxes pertaining to future years. For the year, the profits that the taxman calculates would be higher than those computed in the company's books of accounts.
So, while the company shells out a disproportionately high tax in the current year, it would save on tax in the years when the expenses or provisions actually materialise.
By recognising deferred tax liabilities in its books, a company makes sure that the tax liability for any particular year is reflected in that year's financials and does not carry over to future profits.
It brings investors one step closer to understanding exactly how much of a company's profits for a period are from its operations (rather than from fiscal savings).
