Benefits and limitations of providing for deferred taxation

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Deferred tax is a provision in which stated profit/loss to ameliorate a difference between statutory accounts and your tax accounts. This difference often exists when fully tax-deductible expenses are deducted in one period for statutory accounts and other for tax aims. Accountants call this incongruity.

Deferred taxation liability account is an account on any entity's balance sheet because of short while differences between the entities's accounting and tax amounts, the assumed and enforced income tax rate, and predicted taxes payable for the running year. It can be or cannot be realized during the year.

Deferred taxation provisions

Capital allowances

Unrevealed tax losses

Pension costs

And other short term timing differences

Deferred tax and IAS

IAS12 focuses on temporary differences more rather than timing differences, timing difference is not wider as temporary differences it includes revalued fixed assets and rollover relief and it doesn't not include discounting.

There are three methods to calculate the deferred tax.

Flow through: deferred tax is not provided for.

Full provision: this provides deferred tax on all timing differences.

Partial provision: this reflects the tax this is expected to be paid.

Partial does not apply on pensions and was inconsistently applied, and other standard required full provision. And this all is time differences, partial rely on management decisions whereas it must be responsibility rather than intentions and consistent.

IAS discussed that fixed asset with its general cash flow should be equal at least to its carrying amount and tax is given on these flows, but United Kingdom doesn't accept it.

And they provided two approaches for deferred tax,

Incremental liability

Valuation adjustment

Deferred tax does not give rise to liability but to meet the criteria as an asset is why revalued.

Valuation adjustment doesn't comply with the IAS and estimates but it means netting.

We better explain it with an example, assume a business has accounts profit post depreciation of £57,200 and during the year £8,000 are spent for office equipments, by following the company rules and regulations that the equipment should be write off at 20% per year, after the accounts profit would be £55,600. However fro tax sake; if 100% would be deducted in the year, leaving tax profit would be 47,600. Further with Extensively lower tax rate of 14% the accounts liability on reported profits would be 7,784 but the corporation tax liability would be 6,650.

During the year the tax charge is synthetically lower due to 100% deduction, the tax charge in the next three years will be synthetically higher, because of tax sake the equipments have been fully written off, but they are still being charged at 20% per year because of accounts profits purposes.

We see the example there is timing difference of 6,400 (the £8,000 deducted for tax purposes minus £1600 deducted as depreciation for accounts purposes) and for 14% is £896. Moreover a debit of 6,650 added to the profit/loss account fro corporation tax, and for deferred tax a debit will be £896, in profit and loss account by giving total tax charges of 7,784 that is what the tax charges if accounts profit and tax profit were the same. The provision of £896 will be released in accounting over the next three years, which reduces the tax liability.

Practically the business gives reduced tax first year and increased tax in the coming years. Mean time accounts will show a constant charge for whole period.

Another numerical example can demonstrate more on deferred tax

Income tax paid is at 30% an entity made provision for inventory obsolescence of $4m which is allowed for tax until inventory sold and an impairment charge, this is for future not for the current year and this is against trade receivables of $2m.

The deferred tax provision will be $2m x 30%, i.e.$600,000.

The tax will be the provision and impairment charge for debtors, and higher than the carrying value.

Normally every asset or liability supposes to have a tax base, and that amount is for tax purposes. Whereas some items and assets are not taxable and they are not counted for taxable profit.

Some temporary differences arise

Good will

From the initial recognition of certain assets and liabilities

From investment when certain conditions apply

IAS12 doesn't allow and reduction in value of good will and deferred tax liability for good will.

Deferred tax accounting is very useful for the financial statement users, as it meets the accrual basis and it shows clearly the tax impact on the assets and it shows the impact on the forecast tax rates, however the financial users can predict or can analyse the in term of investment views or for another purposes. Deferred tax liability account shows the future tax and how the event recognised in the financial statements. It is very useful for company employee for investors and for the suppliers, customers and for every user of financial statements.

The big disadvantage of the deferred tax is, it brings forward lots of computation and may result in errors.