In the United Kingdom (UK) profits which are shown in the company's financial statement will form part of the taxable profits from which the company's liability is calculated. However many governments introduce various incentives and disincentives in their fiscal policy for economic and social reasons
Accounting for deferred taxes, as prescribed by Financial Accounting Standards Board Statement no. 109, states that accounting for Income Taxes, can be a complex process. It summarizes the related items in a brief format. It also reflects the relationship between different time periods and provides clear perception into the nature of the various elements related to deferred taxes. It is argued that the rules for deferred tax still remain complex and in some areas and controversial. Some observers argue that deferred tax is simply preparing reports for tax or other financial purposes ("accounting fiction") and that no deferred tax should be documented.
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"Deferred tax is an accounting concept, meaning a future tax liability or asset, resulting from temporary differences between book (accounting) value of assets and liabilities and their tax value, or timing differences between the recognition of gains and losses in financial statements and their recognition in a tax computation" (wikipedia.org Deferred tax).
Deferred tax is said to represent a company's liability for taxes owed that is postponed to future periods. Deferred tax is as a result of tax losses which are carried forward to be used against taxable profits which arise in future. Some expenses which are recognised in the financial accounts for example costs of entertaining customers, fines incurred and development expenses are disallowed. Firms write off expenses faster than they are recognized and thus create a deferred tax liability. Companies can depreciate fixed assets at a faster rate for tax purposes than the actual use of the asset would say. Depreciation is a provision (not deductable) but capital allowances given by the tax authorities computation may differ from the depreciation charge in financial statements In theory, the resulting difference between income under Generally Accepted Accounting Principles (GAAP) and income for tax purposes sets up a deferred tax liability for the taxes owed in the future whereas in actual practice, the deferred tax liability may be postponed indefinitely if the company continues to buy new equipment.
"In February 1999 the Her Majesty Revenue and Customs (HMRC) published an article explaining the view that the timing of the tax treatment of deferred revenue expenditure should follow the accountancy treatment." (hmrc.gov.uk/manuals). However despite this publication, deferred revenue expenditure was being dealt with in different ways. The lack of consistency may have been partly due to having more than one possible meaning or interpretation guidance caused by some wrong advice that did not reflect their publicised change of view. Some guidance as referred by Income Tax Act (S74) (1) (d) provided a timing rule for allowing a deduction for repairs expenditure regardless of accountancy treatment. An example.... "following the Special Commissioners' decision in Jenners Princes St Edinburgh v Inland Revenue Commissioners (1998) HMRC accepted that there is no such authority." (HMRC). Even though other guidance reflected the correct view, previous guidance also suggested a realistic approach in dealing with expenditure posted to fixed assets and this too had not been amended. The ISA 12 income tax prescribes the accounting treatment for income tax which includes the tax assets and liabilities. This arose due to temporary differences which are differences that between taxable profits and accounting profits that originate in one period and reverse in one or more later periods.
According to modern accounting standards in most cases a company is required to provide for deferred tax in line with either the temporary difference or timing difference approach. In this case it if vital to provide for deferred liability as the liability or asset should reduce over time. Certain items of expenditure may be not be legitimate deductions from company profits for tax purposes under tax legislation. This falls under permanent differences because they are disallowed at a different time and in future accounting periods. This happens when the new difference is arising. The main circumstances that give rise to deferred tax is that liabilities are provided in order that investors may understand the future tax liabilities that may arise as a result of increasingly fast tax relief taken to date, or income that has not yet been taxed. However investors viewed deferred taxes as true liabilities, and that legislative changes that reduced the likelihood of paying these taxes had a favourable effect on share prices. The other advantage for deferred tax is that data on assets and liabilities can be used to quantify the potential earnings consequences of changes in corporate tax rates or other policy proposals, an often overlooked effect that may be of interest to policymakers.
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Entities also are expected to disclose information regarding the amounts and expiration dates of loss and credit carry forwards, the division of tax expense between continuing operations and all other items, the composition of earnings before income taxes and temporary differences for which the firm has not recorded a deferred tax liability, including permanently reinvested foreign earnings.
To increase earnings and avoid reporting a loss entities use their discretion in accounting for deferred taxes as this differences are useful measures in evaluating firm performance.
However there are several potential difficulties with the measures of deferred tax assets and liabilities most entities operate under multiple taxing jurisdictions, but do not disaggregate income tax disclosures by jurisdiction. In the United States of America (US) it difficult to determine how changes the country statutory tax rates alone would impact the reported Deferred Tax Assets (DTAs) and Deferred Tax Liabilities (DTLs). State statutory tax rates are by far lower than federal statutory rates, so the state and local limitation is likely less severe than the foreign limitation.
By assuming that all deferred tax assets will be affected by a change in the statutory rate, this may overstate the effect of a statutory rate change. Entities may make different additional assumptions in computing and presenting the value of DTAs and DTLs. These differences may lead a statutory tax change to the policy environment to have different impacts on different firms.
Although deferred tax positions for larger firms are a concern, addressing this concern cannot be eliminated, especially since merger and acquisition activity can itself affect deferred tax positions. For example, a company with a deferred revenue liability that received cash and paid income tax on that cash, may not record the cash as revenue until the related goods or services were delivered would have a deferred tax asset. A firm with instalment sales, which recognizes a gain for book purposes when the sale closed but recognizes the gain for tax purposes as the payments are made, would have a deferred tax liability. With recognition of deferred tax asset in full and an offsetting valuation allowance in that this approach should encourage financial preparers to be care full in calculating the net amount of deferred tax asset which is of the full amount of deferred tax assets and its valuation allowance.
It is augured that large firms in most industries are more diversified, and less likely to experience tax losses than smaller ones. It is also possible that large companies keep in more business control transactions than smaller ones, thereby inducing different levels of goodwill and deferred tax assets than one finds at smaller firms. To measure reliably the deferred liability or asset tax arising from temporary differences relating to an investment and unremitted profits in a foreign subsidiary or joint venture that is essentially permanent in duration is often not possible. Some take the view that at it is an obligation to pay tax when a company has taxable profits but not in accounting profits and a result does not affect accounting treatment. Taxation is calculated on a cash basis while financial profit is calculated on an accrual basis. Some argue that under accrual basis accounting it is necessary to recognise the tax effects of all taxable income and tax deductable expenses for the period in which they were recognised not in the period they form part of the taxable profit hence this will result in a deferred tax due to timing differences.
In the US for example, Statements of Financial Accounting Standards (SFAS) 115, Accounting for Certain Investments in Debt and Equity Securities, which took effect in 1994, changed the accounting principles governing investments in debt and equity instruments. Before SFAS 115, gains and losses on debt and equity securities were recognized in both book and tax income at the time of sale. Under SFAS 115 firms may classify their security investments to recognize unrealized security gains and losses either in net income or in other comprehensive income. Though tax recognition rules for security gains and losses have not changed, SFAS 115 created a temporary tax difference and generates a deferred tax position
SFAS 109 in relation to Accounting for Income Taxes, which took effect for fiscal years beginning after December 15, 1991, prescribes the current rules governing deferred tax assets and liabilities. Companies are required to report not just a net deferred tax position, but both deferred tax assets and deferred tax liabilities. "Deferred tax positions are presented on the balance sheet based on current/non-current classification, as determined by the current/non-current status of the underlying asset or liability that gave rise to the deferred tax position."(SFAS 109)
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Although different entities face different situation, policy changes that affect deferred tax assets and liabilities are likely to have material consequences for many large corporations. The way policy changes affect deferred tax assets and liabilities can be an important for designing relief that minimizes the adverse effect of changes in tax policy or accounting rules on affected corporations therefore in my opinion should be accounted provided it is for equitable distribution of economic and social reasons.